A few questions for my Austrian readers

My view of the period from mid-2006 to mid-2008 is as follows:

Too much capital was allocated into housing during 2004-06.  After the U.S. housing market peaked in mid-2006, for the next two years we had a mildly painful readjustment, as resources were moved out of housing and into other sectors of the economy.  Because it is difficult to re-allocate resources, the structural unemployment rate crept up from the mid-4s in mid-2007 to the mid-5s a year later.  Other sectors of the economy kept growing.  There were no signs of bubbles in U.S. manufacturing, which grew at the normal rate during the previous expansion, and of course manufacturing prices were well-behaved (unlike housing.)  The big bubble was in housing, and after 2006 we had to go through a painful readjustment as labor and capital was re-allocated to other sectors.

Is that right?  If this is the Austrian story, then I think it is a good explanation of that two year period.  What confuses me is what happened next:

1.  Why did NGDP collapse late last year?

2.  Could a suitably expansionary monetary policy have stopped NGDP from collapsing?

3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

4.  Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s.  He later changed his mind and argued that the Fed should not have allowed NGDP to collapse.  Was he right to change his mind?

5.  If monetary policy could not have prevented an NGDP collapse, what is your story?  Is it the Keynesian liquidity trap?  (I assume the answer is no.)

6.  If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?

7.  If the answer is no, why not?  Wouldn’t that have prevented the collapse in manufacturing in Asia late last year?  What is the structural imbalance corrected by having 10s of millions of Chinese lose jobs making stuff like shoes?  (Presumably there was no shoe bubble.)    Are Austrians worried about the U.S. trade deficit?

What I am basically asking here is if the housing bubble was the problem; shouldn’t there have been enough NGDP growth to support the non-housing parts of the economy, while allowing housing to decline as necessary?  I get why we needed housing to decline for eight straight quarters from mid-2006 to mid-2008, but I don’t get why we then needed to violate Hayek’s maxim to keep NGDP from falling, and let NGDP fall sharply—causing massive output declines in sectors completely unrelated to the housing bubble.  Recall that those non-housing sectors held up well during the first two years of unwinding the housing bubble–so we are not just talking about manufactured goods like rugs and furniture.

I may not post this week because of exams, perhaps we can have a conversation about Austrian macro.

Oh, and one other question:  As you know I am completely contemptuous of those (mostly Keynesians) who use interest rates as an indicator of monetary policy.  Interest rates were very low in American in 1931; and very high in Germany in 1923.  I believe that interest rates tell us precisely nothing about whether money is too easy or too tight, especially short term rates.  The key variable is NGDP growth (which I believe Hayek also favored targeting.)  Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?

BTW, In case anyone wants to revisit Tyler Cowen’s banana post, I have a different perspective on the Hayek vs. Minsky debate.  I think they are both wrong.  Can you guess why?

Update (4/29/09):  A number of people have emailed two very useful links.  I thought I would attach them here to further the discussion. The first is a slide show by Roger Garrison.  In the second Lawrence White discusses the views of Hayek during and after the Great Depression.  Bill Woolsey says that both White and Garrison have a Hayekian approach to Austrian economics, which seems closer to my view than the Rothbard approach.  A few comments:

1.  In the slide show, I like Hayek’s approach better than Keynes’.  Hayek argues that misleading interest rate signals can make people try to consume more and invest more at the same time.  This pushes production past the PPF, and also leads to a lot of inefficient malinvestment.  He argues that investment exceeds saving during this boom phase, and that the gap is filled by newly created money.  I have a few problems with this.

a.  I don’t think investment exceeds saving during the boom.  Rather I would argue that both consumption and saving rise during booms.  How can this happen?  In my view the expansionary monetary policy causes NGDP to expand.  Because wages are sticky, real output also rises.  Because both real and nominal income increase, both real and nominal C and S can also increase.  I don’t like the “money filling the savings gap” story, as you would get the same sort of inflationary boom from a drop in money demand, as from a rise in the money supply.  I also don’t think that interest rates are a useful indicator of monetary policy.

2.  When the inevitable relapse sets in, output falls back to the PPF.  In Hayek’s view, this is desirable.  I agree.  I believe this was occurring between 2007 and mid-2008.  But Garrison also mentions the danger of overshooting, of output falling far below the PPF.  I believe this is called a secondary depression.  I believe a secondary depression began late last summer or early last fall.

3.  Regarding the JMCB paper by White, I am merely going to comment on pages 26 and 27.  Hayek says that he initially thought that monetary policymakers should not attempt to arrest the deflation through monetary expansion.  But later he came to realize that the monetary authority needed to act aggressively, to do everything possible to prevent falling NGDP.  He thought the central bank should increase M enough to offset the fall in velocity.  This is also my view.  It seems that Hayek later came to realize that the Great Depression was a sort of secondary depression—the bad kind of downturn.

During the 1930s there were basically three views of the Great Depression:

1.  Not caused by tight money; and a needed corrective for overexpansion of investment (and malinvestment) of the 1920s.  Many conservatives held this view.

2.  Not caused by tight money, but also highly undesirable.  It needed to be corrected with aggressive government stimulus.  This is the Keynesian view.

3.  Caused by tight money, or at least errors of omission by the Fed.  It was also highly undesirable.  This is the modern view of mainstream macroeconomists.  It is also my view.

Regarding the current cycle, there are also three views.  And at least regarding what I call the “secondary depression”–beginning last fall, they are precisely the same three views that economists held regarding the Great Depression.  Only in this case the third view is held by only a tiny number of economists (me, Earl Thompson, and a few commenters on my blog.)  I believe it is also the view Hayek would hold if he were alive today, and I also believe it will eventually become the mainstream view, as it eventually did for the Great Depression.

(I am not done with the liquidity trap/interest on reserves question, and the causality question—but I need more time to focus on them.)


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191 Responses to “A few questions for my Austrian readers”

  1. Gravatar of DWAnderson DWAnderson
    28. April 2009 at 08:11

    I’m not sure I’m an Austrian reader, but I suspect that the effects of the runup in housing prices were more widespead than in your initial story.

    Here is my hypothesis: The prices of housing declined significantly from late 2007 to early 2009, that had a significant effect of peoples’ wealth. Because they felt much poorer, the consumed less and the mix of goods they consumed changed. Concurrently, the decline in housing prices caused significant losses at leveraged financial insitutions and the costs of that financial distress manifested themselves in the panic of late 2008 with the net result that those institutions needed to make big adjustments to how they did business. The changed consumption patterns and the big adjustments at financial institutions resulted in large stock declines, which led to more consumption decreases and adjustments.

    All those adjustments were really big resulting in significant NGDP declines.

    If you had more expansionary monetary policies, you would have made the post 2006 adjustments take even longer.

    This is just a hyppothesis based on my memory of events, so I would be curious to know what data support or refute it.

  2. Gravatar of azmyth azmyth
    28. April 2009 at 08:15

    It seems to me that the guys over at the Mises Institute are far more upset by the way fiscal policy has reacted to the crisis than the monetary response (for a good example: http://mises.org/story/3333). I don’t know what Hayek would say, but I think your argument that good monetary policy can prevent bad fiscal policy would probably convince some Austrians. The deflation we are currently experiencing is pretty clearly George Selgin’s bad deflation since it does not stem from productivity increases, but from a collapse in demand (http://www.amconmag.com/article/2009/feb/09/00014/). Finally, I don’t think the Austrian theory suggests that the downturn has to be symmetric with the upswing. As long as the malinvestment is cleared out from the system, growth can continue as usual. Sectoral shifts don’t have to be long and painful.

  3. Gravatar of ssumner ssumner
    28. April 2009 at 08:41

    DWAnderson, Welcome fellow UC alum. Sorry, but I just don’t see how any of the things you mentioned would cause NGDP to fall. And even if they did, why not use monetary policy to prevent NGDP from falling? When we did that, in 2006-08, the real estate decline did not cause any big problems for the macroeconomy. When we stopped doing that, the non-housing sector tanked. I don’t see why the post mid-2008 crash is a good way to handle the decline of the housing industry. Wasn’t the previous 2 years a much better way to handle the problem?

    If Americans are poorer, it’s partly because of falling AD. But even the very real part of falling wealth that is due to misallocation of resources shouldn’t cause a big jump in unemployment in industries totally unrelated to housing. The drop in NGDP is affecting almost all industries. The solution to poverty is to work harder, not stop working in other industries and get even poorer.

    Finally, I don’t know what you mean by post-2006 adjustments. I am arguing that some of the adjustments that are occuring (a collapsing manufacturing sector in Asia for instance) are adjustments that never should have occurred at all.) Some have argued there was a bit of overcapacity in manufacturing. But doesn’t falling demand for manufactured products make that overcapacity even worse? It seems to me we aren’t making “adjustments,” as in the 1930s we are making “problems” that didn’t even exist in the 1920s.

    azmyth, I hope you are right. If so I am not far apart from the Austrians. I have always viewed my preference for 2% inflation as tangential to my central argument. I would make virtually the identical argument if someone (Selgin?) convinced me we should have negative 2% inflation. I’d just argue for 1% NGDP targeting, but I’d still make the same critique of current Fed policy.

    Changes in the long run trend rate of inflation are neutral in the long run, because of the Fisher effect they don’t have long run effects of much importance (except higher implicit taxes on capital.)

  4. Gravatar of hibida hibida
    28. April 2009 at 09:41

    I am not an Austrian expert but here is my take:

    1. Why did NGDP collapse late last year?
    –The US NGDP is not based on real wealth. By that I mean the numbers that go into NGDP do not represent the real wealth of the US, which is our production capacity. When the housing market tanks and the stock market tanks our NGDP also tanks because the NGDP has become a measure of the “paper value” of the us economy. This is not good from an Austrian perspective. A strong economy has real wealth (production capacity) not fake paper wealth.

    2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?
    –It could only have prevented a collapse and make the eventual collapse worse. We are experiencing this right now. After the Dot-Com collapse, “a suitably expansionary monetary policy” helped create the current predicament.

    3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?
    –I am not well versed enough in Hayek’s thought to make an educated guess at what his actions would be, but no Austrian favors artificial monetary expansion. Austrians want to get ride of any governing body that has control over the money supply. The Fed or any central bank can only do harm in the long run.

    4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?
    –Again, I will not speak for Hayek but Austrians think the Fed should not exist, so they can’t really support any action from the Fed. That is unless the Fed wants to close its self down!

    5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)
    –No! Reckless monetary policy, defined as any reactionary policy that focuses on the short term ( quarters and years, rather then 5-10 year time frames), can only do harm. Let NGDP fall! That is what is needed. Pain for all in the short term, but in the long term, prosperity will return and we will be better off.

    6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?
    – Can you guess my response? …
    Of course the Fed should NOT have tried to do anything. They should have just sat and watch the interest rates go up like the market wanted them to.

    7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese loose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?
    – The collapse in manufacturing in Asia could only have been delayed, and eventually would have become worse. More Asian capital would have been allocated poorly, creating more shoes that Americans can’t afford.
    Yes, Austrians are worried about the U.S. trade deficit, but only because of why the trade deficit exists. A trade deficit is not inherently bad but the U.S. one is. The US trade deficit is bad because it correlates ( not directly) with the “production deficit” in the US. By this I mean the US no longer can produce the goods that US consumers want. The lack of productive capacity in the US is what bothers Austrians, because production is what drives a healthy economy, not consumption.

    Your last question:

    Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?

    No, I do not agree. During this time, the money supply was growing big time and it was obvious that monetary policy was very expansionary. It was obvious because interest rates should have been higher ( we needed a correction after the Dot-Com crash). The only way for the rates to be that low was for an aggressive printing press. The same thing is obvious right now. The Fed’s monetary policy today is very expansionary.

  5. Gravatar of Thruth Thruth
    28. April 2009 at 11:43

    Hi Scott,

    Been a while since I commented. Have been enjoying the posts immensely.

    Here’s my guess of what the Austrians might be thinking:

    I think mainstream macro notions of “capacity” and “potential” are nonsense to Austrians. These measures are simply part of the false signal markets receive and react to during the malinvestment stage. Malinvestment means “false” wealth is created, which results in demand that should never have been. Presumably they would claim that propping up demand will not improve welfare.

    As for why the shock has shown up everywhere, not just in housing, I think that follows from world and sectoral integration. You stop buying my junk paper, I stop buying your lead-filled toys. Why did it take so long to manifest itself: well the Fed kept the party going until it ran out of rope in late 2008 and at which point Fed actions start looking fiscal and might have a real cost.

    The raft of data showing what appears to be monetary policy failure (or failure of monetary authorities) around Oct 2008 — probably beside the point to an Austrian — I think you just have to close your eyes and start chanting “follow the yellow brick road”

  6. Gravatar of johnleemk johnleemk
    28. April 2009 at 11:52

    azmyth:

    Really? My impression of the Austrian response is that as upset as they are with the fiscal policy response (sentiments which many non-Austrians seem to share), they are also outraged by the general behavior of the Fed and its quantitative easing (which Scott has suggested is still not enough to reinflate NGDP).

    Perhaps you have a certain kind of Austrian in mind — some Austrians like “The Austrian Economists” (a popular blog) seem levelheaded and openminded to an argument that the Fed could do some good. But there are also a lot of “vulgar Austrians” (a term I coined as the flip side of the “vulgar Keynesians” Krugman once criticized) who strongly believe that the Fed should be abolished and that monetary policy should not be used to address the present situation. This vulgar Austrian ideology seems pretty popular to me, and it was a key plank in Ron Paul’s campaign for the presidency.

  7. Gravatar of ssumner ssumner
    28. April 2009 at 12:17

    I understand that some Austrians want to abolish the Fed. But if that’s the only answer I can get, it doesn’t really help me very much. And I have no idea what people mean when they say the Fed should “do nothing.” Or perhaps I should say that I know lots of things it means, but everyone I meet seems to have a completely different idea. Doing nothing to interest rates is doing a lot to the money supply, and doing nothing to the monetary base is doing a lot to the M1 or M2 money supply. I know that lot’s of Austrians have advice for the fed, so let’s proceed under the assumption of the Fed’s continued existence for a while, and consider how we make the best of the situation.

    I certainly hope Austrians aren’t saying it’s necessary for the production of everything to go down, I had thought that “general glut” idea was discredited after the 1930s. I had thought Austrians didn’t believe in aggregates, and said you had to look at sectors. That sometimes there was too many resources allocated to some sectors, and too little to others. I certainly hope they are not claiming there was too much of everything in 2006, and now we need a lot less of everything (except “leisure time,” aka unemployment.)

    I would also be interested in knowing whether hibida is right about short term rates. Do Austrians actually think short term rates are a good indicator of the stance of monetary policy? If so, it would save me a lot of time—we could just move on to other topics. hibida says he’s not an Austrian expert, so I’d like other views on this. I have never understood why people thought monetary policy was so expansionary in 2002-03.

  8. Gravatar of Greg Ransom Greg Ransom
    28. April 2009 at 13:06

    Scott — one of the top “Austrian” macroeconomists — Roger Garrison — has a dual explanation of what has been going on over the last few years. (See Garrison’s FEE lecture from early last year.) This is not unusual. Bank of International Settlements chief economist William White used Hayekian macro in conjunction with an account of other pathologies in the financial system to explain and anticipate what was going on (reports made in 2004, 2005, 2006, and 2007 — and in personal conversations with Alan Greenspan in 2003.)

    Hayekian macro does _not_ exclude other causal and explanatory stories and factors.

    Vernon Smith in the WSJ wrote an important piece on the special role of mortgage foreclosure in various cycle episodes. There is nothing inherently “anti-Austrian” in any of those facts or any of that story.

    Historical explanation is messy — “Austrians” would be the first to tell you …

  9. Gravatar of Joe Calhoun Joe Calhoun
    28. April 2009 at 13:12

    Well, I’m not an Austrian, but I stayed at Holiday Inn Express and I’ve watched a bunch of Schwarzenegger movies so…..

    1. Why did NGDP collapse?
    NGDP collapsed because the productive parts of the economy were starved of capital during the real estate boom years. The malinvestment in real estate destroyed capital and since real investment can only be funded by real savings, you need a period of time to rebuild savings.

    2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?

    Yes, but it wouldn’t be desirable since it would only set off another round of malinvestment. Expansionary monetary policy gives false price signals to enterpeneurs to invest in long term projects that may not be viable when monetary policy is normalized.

    3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

    I have no idea, but based on what Hayek I’ve read, I have my doubts.

    4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?

    For the Austrians I know, absolutely not. As someone above pointed out, Austrians don’t think the Fed should even exist.

    5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)

    See 2 above

    6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?

    Again, see 2 above

    7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese loose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?

    The consumption boom fed here by the credit bubble also fed a boom in manufacturing in Asia that was unsustainable. The manufacturing overcapacity created in Asia needed to be corrected. Expansionary monetary policy to try and avoid the collapse in NGDP would have merely delayed that process.

    I don’t think Austrians are particularly concerned with a trade deficit. They see it as a consequence of the monetary boom. Absent the monetary manipulations of the Fed, the trade deficit wouldn’t have been of sufficient magnitude to cause a problem. Monetary/credit booms are often accompanied by trade deficits. Murray Rothbard’s book about the Panic of 1819, talks about a large rise in the trade deficit after the War of 1812 which he blames on monetary expansion by state banks and the Second Bank of the US.

    The Austrian view places a big emphasis on capital. In the Austrian view, monetary and fiscal manipulations to mitigate the pain of the correction merely delay the recovery because they delay the process of rebuilding the capital base. Deficit spending (dissaving) just offsets the positive of the increase in the private savings rate. Monetary expansion just creates malinvestment which destroys more capital.

    I think the Austrian view is largely correct. The panics of the 19th century were deep but relatively short. The 1819 panic (which I mentioned above) was basically ignored by President Monroe and it was over in roughly 18 months. Another example used frequently recently is the mini depression of 1921 which was similar in duration.

    Having said that, I have a problem in saying we should just let this run its course. The pain for individuals in correcting a bubble of this size would be enormous and the social costs in my opinion would be too great.

    It seems to me that what we should be concentrating on, while we mitigate the circumstances and do as little damage as possible, is the real cause of all this. Like the Austrians, I tend to see it as a massive failure of monetary policy, not just in the years after the dot com bust, but for many years prior. We need to find a better way to control monetary policy in the future (which is one reason I’ve been reading this blog) so we don’t build up the excesses that got us here. Unfortunately, the politicians (and of course the Fed) don’t see this as a failure of monetary policy but rather a failure of regulation.

    Lastly, the Austrians do place quite a bit of emphasis on interest rates. They see the manipulation of interest rates as manipulating the time preference of savers and investors. That distorts savings and investment and creates the malinvestment.

  10. Gravatar of ketzerisch ketzerisch
    28. April 2009 at 13:13

    @johnleemk:

    - “Perhaps you have a certain kind of Austrian in mind — some Austrians like “The Austrian Economists” (a popular blog) seem levelheaded and openminded to an argument that the Fed could do some good.”

    The Fed can certainly do some good.

    - “But there are also a lot of “vulgar Austrians” who strongly believe that the Fed should be abolished and that monetary policy should not be used to address the present situation.”

    I think these are two different points. The Fed should be abolished as, while it can do some good, it is in my point of view not enough to offset the bad it does. The interest rates are by far the single most important price in the economy. They tell me if I should consume or better save for my retirement. That price should not be fixed by anyone but the market.

    But to abolish the Fed in the middle of a crisis, well, that is what I’d call vulgar.

  11. Gravatar of Greg Ransom Greg Ransom
    28. April 2009 at 13:16

    Scott — note well that the “needed correctives for excesses” picture is not one found in Hayek, it’s the false picture of his work provided by people who wish to marginalize Hayek and demonstrably don’t “get” his causal story, i.e. it the false picture of “Hayek” you get from hostile witnesses. I’d recommend Garrison’s work for an extended discussion of the difference between this false picture of Hayek and his actual model.

    One thing you need to know about Hayek is that he spent almost all of this time working on theory and teaching, his interest at the time was mostly the British one that dated from 1925 — and appreciate that the data known at the time was pretty weak and often bad. So you can’t assume Hayek was commenting on an empirical situation he really had any sound knowledge of at the time.

    Scott writes:

    “Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?”

  12. Gravatar of Jon Jon
    28. April 2009 at 13:26

    Scott:

    As you have suggested in other contexts, the Austrian analysis makes sense in the context of an implicit ‘zero inflation’ standard. If the CB pushes production by suppressing the short-rate, then it must later induce deflation to restore the price-level. The longer the CB has pushed production the harder/longer it must induce deflation to meet a zero inflation target.

    With this in mind, the Austrian argument reduces to an explanation for why an above trend CB stimulus must be followed by a subsequent bust when policy is reined in. Their argument is that interest-rate stimulus is not agnostic. Certain sectors are stimulated more than others b.c. capital is a more dominate input to those sectors. This is necessarily a distortion then among the production possibilities. Therefore, inflation must arise.

  13. Gravatar of ketzerisch ketzerisch
    28. April 2009 at 13:40

    Scott,

    “I certainly hope Austrians aren’t saying it’s necessary for the production of everything to go down”

    No. I don’t think that Austrians say such a thing. Indeed they think that while _world_ production has to come down and shift to products with are actually demanded, the US production has to go up. The USA lived well beyond their means for quite some time. Now it’s time to save and produce (or default on the debt).

    “I had thought Austrians didn’t believe in aggregates, and said you had to look at sectors.”

    I think they do.

    “That sometimes there was too many resources allocated to some sectors, and too little to others. I certainly hope they are not claiming there was too much of everything in 2006, and now we need a lot less of everything (except “leisure time,” aka unemployment.)”

    I never heard someone claiming this.

    “I would also be interested in knowing whether hibida is right about short term rates. Do Austrians actually think short term rates are a good indicator of the stance of monetary policy?”

    No, that would be foolish. Indeed, long term rates are much more important. But they too are manipulated by the central banks. However, Austrians focus on real rates.

    “I have never understood why people thought monetary policy was so expansionary in 2002-03.”

    As far as I recall, according to Taylor’s Rule it was quite expansionary in 2004-05. An Austrian run economy would not have such a thing as a “monetary policy”.

  14. Gravatar of Greg Ransom Greg Ransom
    28. April 2009 at 14:08

    I’ve cleared some clutter, now lets answer the questions:

    1. Why did NGDP collapse late last year?

    The answer is overdetermined and complex — involving bad regulations, bad money policy, outright fraud, bad decision makings, etc. — but all of these things together worked to systematically distort relative prices across every dimension of the time structure of production goods, investment, and consumption.

    2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?

    Temporarily, not indefinitely. Did the perfect storm of multiply revealed multiple causation have to happen all at once? No.

    Here’s a better question. Could a non-expansionary monetary policy have stopped the artificial boom from building in the first place? To the extent distortions didn’t come from the pathologies of the financial regulatory scheme, or the artificial boom wasn’t in part caused by “enthusiastic expectations” created by credit and money from China, etc.

    And note well. It’s a different question to consider whether _after_ the popping of the artificial boom and the onset of the inevitable bust, looser monetary policy might not help deal with a collapsing NGDP created by a bust phase “secondary deflation”

    3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

    Trick question. Hayek would have opposed the original expansionary monetary policy which created the artificial boom and inevitable bust in the first place.

    He then would have said that without accelerating inflation, there is no way to prevent the inevitable bust after the original distortions.

    Finally, if the bust phase produced a deflationary downward spiral, he would have favored a monetary policy which stopped this deflation. This isn’t an expansionary policy, it’s an anti-deflationary policy.

    4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?

    Hayek learned more about what actually happened over several decades. He never studied the empirical facts very closely — I don’t think he ever really knew the facts about U.S. mortgage institutions and state banking, etc.

    Hayek saw the British depression as beginning in 1925 with the British return to the Gold standard at par. He saw the boom in America as artificial, involving much misallocation across the time structure of production, producing an inevitable bust. He came later to see the historical episode as very complicated, with trade tariffs, government policies, etc. complicating the story enormously. He came to say that his “Austrian” theory fit the facts of 19th century booms and bust better than 20th century booms and bust, in part because of the changed complexities of the institutions involved and the changes in finance, etc.

    Hayek never changed his mind that the Fed had the wrong monetary policy between 1927 and 1929 — and that there was some degree of a misallocation of resources.

    He later came to realize that the Fed screwed up with a massive deflation in the 1930s — and that there was a problem of a secondary deflationary downward spiral. His idea here is that the Fed should have acted to stop this deflation, _after_ the start of the inevitable bust, which could _not_ have been avoided. A small downturn was inevitable. A massive Depression with insane government interventions (i.e. the tariff, etc.) and a depressionary downward spiral was not.

    5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)

    A small downturn was inevitable — resources were misallocated and had to be reallocated, relative prices had to adjust, etc., but a massive NGDP collapse was not inevitable. Bad institutions, bad interventions and bad Fed policy were needed for that.

    6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?

    Wrong question. A small downturn was inevitable. A non-deflationary policy couldn’t have prevented that, but would have helped prevent the massive NGDP collapse. Other things also would have helped — like no tariff, no propping up of wages, no NRA, etc. As I say, Hayek was no historical of economics, so there’s no evidence he know much about the facts on the ground here. Read Robert Higgs to see the account of a “Hayekian” who does know the facts on the ground, better than most anyone.

    7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese loose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?

    See Roger Garrison’s Power Point on Hayekian Macro at his web site, and his head to head comparison with Keynes, to get some picture of how there is both too much consumption and misdirected “over” investment at the same time during the artificial boom. Trust me, you will understand this if you watch the Garrison power point. The choice to understand this is yours.

    >>What I am basically asking here is if the housing bubble was the problem; shouldn’t there have been enough NGDP growth to support the non-housing parts of the economy, while allowing housing to decline as necessary?<>I get why we needed housing to decline for eight straight quarters from mid-2006 to mid-2008, but I don’t get why we then needed to violate Hayek’s maxim to keep NGDP from falling, and let NGDP fall sharply—causing massive output declines in sectors completely unrelated to the housing bubble.<> Recall that those non-housing sectors held up well during the first two years of unwinding the housing bubble–so we are not just talking about manufactured goods like rugs and furniture. <<

    The whole time structure of production and consumption gets out of whack in the Hayekian story. Every relative price gets distorted. Try to use your imagination to picture that. The whole structure across time, with different production processes, and different consumption schedules.

  15. Gravatar of Gabriel Durazo Gabriel Durazo
    28. April 2009 at 14:11

    “What is the structural imbalance corrected by having 10s of millions of Chinese lose jobs making stuff like shoes? (Presumably there was no shoe bubble.)”

    I’m no expert, and don’t know Austrian ideas enough to call myself one, but I might hazard a guess at the answer here.

    The structural imbalance is that the demand for shoes was far too great because of the housing bubble: People who shouldn’t get houses get them. A “bubble” in housing means misplaced demand and artificially high prices, giving these people inappropriate wealth. This “bubble wealth” is spent on shoes and other consumer goods like that, signaling the wrong level of demand to the Chinese shoe companies.

    Too high of demand leads to too much employment in shoe making companies. The housing bubble pops, the “bubble wealth” disappears, and the true demand for shoes emerges, leading to those shoemakers losing their jobs.

    So I just made that up obviously, but it sounds at least sort of plausible to me. So I guess I’m saying that there was a shoe bubble.

  16. Gravatar of Greg Ransom Greg Ransom
    28. April 2009 at 14:11

    Sorry, I thought questions #5 and #6 were about the Great Depression.

  17. Gravatar of Bogdan Enache Bogdan Enache
    28. April 2009 at 14:13

    Dear professor Sumner,

    Here’s an attempt to answer your questions from my understanding of “Austrian Economics” :

    1. NGDP collapsed because of “credit destruction” following the housing bust, deleveraging, high market uncertainty and risk, increase of money demand, at to a certain extent a fall in productivity.

    2. I think no, not entirely because people have to adjust their expectations and adjustments must be made in line with the underlying situation and monetary policy, like any monetary policy, has lags

    3. Yes, the later Hayek, at least, would be in favour of preventing what he termed a “secondary deflation”, especially under conditions involving highly sticky prices and especially highly sticky wages

    4. Yes, he was right, especially given the structural conditions of economies at that time

    5. The central bank can prevent a collapse in NGDP, but it cannot do this in an instantaneous way, as it were, and it cannot do this in a way that will assure the ideal of monetary neutrality that Hayek and other “Austrian” economists thought should be the standard for monetary policy in a market economy

    6. Yes, it should try to make the best of a bad situation as long as it exists, but because of the inherent difficulty in achieving “monetary neutrality”, the “knowledge problem” that apllies to monetary central planning as well, and the usual public choice reasons it is very likely that it will overshoot or undershoot in its response

    The “bubble” is a misallocation of capital over time which translates at the real level into capital consumption and reveals a discoordination in the production function of the economy. This capital consumption and misallocation therefore has consequences for the overall economy, including China. The sectors which were not overexpanded directly has suffered spillovers and therefore have to readjust as well to the a new production function and this is not a timeless or a costless process. It’s not a theory of a general glut, that would be impossible according to Say’s law, but a theory about an inadequate structure of production, a discoordinated combination of capital goods, capital goods that don’t fit together.

    Short term interest rates don’t tell everything about the stance of monetary policy, but they’re far from meaningless. They have an important signalling role for businesses and consumers.

  18. Gravatar of É possível um diálogo com neoclássicos? « De Gustibus Non Est Disputandum É possível um diálogo com neoclássicos? « De Gustibus Non Est Disputandum
    28. April 2009 at 15:07

    [...] um austríaco? Sim. E, melhor ainda, ninguém se furta a um debate não-messiânico. Como o prof. Sumners. Ciência é assim: aos [...]

  19. Gravatar of Devin Finbarr Devin Finbarr
    28. April 2009 at 15:18

    Scott,

    I highly, highly, highly recommend this post by Mencius Moldbug which gives something of a neo-austrian take on the banking crisis: http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html. Of all the outsiders/Austrians who have been following and writing about the crisis, Mencius is the best. He’s against fractional reserve, but he’s not a deflationist. I think you might find him quite interesting. He also has a great post from late 2006 ago where he pinpoints the exact flaws in the system that were about to blow up.

  20. Gravatar of Bill Woolsey Bill Woolsey
    28. April 2009 at 15:19

    Scott:

    The Austrian theory is about a reallocation of resources. Generally, the criticism of using monetary policy to prevent or reverse a drop in nominal income would be that it will creat additional (or leave in place existing) malinvestments. These will need to be resolved later. Better to get it all done now.

    The Rothbard version, which is consistent with the later Mises, is that all prices (including wages, of course) should adjust so that the real money supply equals money demand. Then there will be sufficient real aggregate demand to match the productive capacity of the economy.

    Increasing the money supply, as an alternative to a sufficiently low price level, again, will result in a misallocation of resources. Those areas of the economy where the new money is spent first will expand at the expense of the rest of the economy. A sufficiently low price level, on the other hand, will allow the composition of production to properly match the demands of households for the variety present and future consumption goods and services.

    There is, however, a complicating factor. In the classical Austrian story, the money creation promotes the production of capital goods used by firms to expand production. The misallocation of resources, then, expands the productive capacity of the economy. Total production is really high during the boom. When resources are reallocated to producing other things (consumer goods,) then total production will fall.

    Tremdous effort has been devoted to showing that the capital goods build up in the boom will not allow a permanent increase in consumption. They are the wrong capital goods. It is malinvestment and not “overinvestment.”

    I am not sure how this would be relevant to investment in single family homes.

    The Hayek version of the theory, which is consistent with the approach of Garrison, White, Selgin, and Horwitz, argues that macroeconomic equilibrium requires that nominal income be stabilized. The money supply should adjust to offset changes in velocity. If monetary policy should cause an increase in nominal income (say, as needed to keep the price level stable in the face of productivity growth, much less to cause a 2% trend inflation rate) then malinvestments are created.

    Those of the Rothbard/Mises group insist that base money should be frozen. The White, Selgin, Garrison, Horwitz group favor free banking, believing that free banks will stabilize nominal income by adjusting the quantity of money to offset changes in velocity. I guess they would accept that if the Fed could manage that, it would be the proper policy and, in particular, its failure to do so, is reponsible for macroeconomic problems. (Actually, frozen base money, with free banking, is supposed to allow for stable nominal income. The Rothbard group favor 100% reserve banking so that the money supply remains equal to base money.)

    I believe that the White, Selgin, Garrison, and Horwitz group would accept that an increase in base money that offsets a decrease in the money multipier and velocity and so prevents (or reverses?) the drop in nominal income over the last 6 months would be desirable. However, returning nominal income to its past growth path..that is, anything with a growth rate greater than zero, would maintain or cause new malinvestments.

    Because Austrian economics has a broad “lay” following, many of whom like to post on economics blogs, you can find people repeating variations that violate basic economic principles like scarcity. Yes, there is some “general glut” type claims, often associated with claims that debt is too great. But, they don’t really understand economics, much less the Austrian version.

    Rothbard is very good about explaining the relationship between a “general glut” and an excess demand for money. It is just that he is very insistent that the _only_ proper solution is an increae in the purchasing power of money (though he gets a bit picky about calling this a lower price level) and so, an increase in the real supply of money to meet the demand. This then, necessarily fixes any apparent “general glut.” And while that means that real aggregate demand is rising to meet productive capacity, Rothbard, and most Austrians would again, get a bit picky about those terms. Still, the general glut is impossible with the proper real quantity of money.

  21. Gravatar of Bob Murphy Bob Murphy
    28. April 2009 at 15:39

    Scott,

    Awesome blog post. I am still in shock from a U of C guy who has read a bunch of Austrian material. (I don’t mean because U of C people aren’t readers, I just mean that it is more gratifying if someone from the top school does it.)

    I intend to answer your quiz on my own blog; I’ll post a link here when I do. But before this gets jammed with a million other comments, I wanted to correct one subtlety you are missing. (And note to those who don’t know me, I am definitely a vulgar Austrian. I think market prices are perfectly capable of changing in the face of economic realities, and that printing up green pieces of paper and handing them to politically connected financiers doesn’t make society richer. Yet this blog abounds with monetary cranks, so I won’t dwell on the point.)

    Anyway on to Scott’s understandable misunderstanding of one point:

    “I certainly hope Austrians aren’t saying it’s necessary for the production of everything to go down”

    Actually, I would argue that it is necessary for real GDP (if we suspend our disbelief in such macro terms) to drop following an unsustainable boom period, even if prices and wages are perfectly flexible. This is because capital is consumed (unintentionally) during the boom period. So even if labor and other resources could magically switch to their sustainable sectors the day after the bust, the economy would still be producing less than it would have on the original growth trajectory, before the Fed distorted things.

    At the risk of sounding immodest, I heartily recommend this piece I wrote where I came up with a fairly simple and (I hope) entertaining parable of Paul Krugman getting washed up on an island and telling the natives how to rearrange their production structure. I give a very simple numerical illustration of what I’m talking about. You can even see why unemployment needs to go up temporarily while the capital structure is repaired following the boom.

    Last point: Of course, just because I can come up with a simple model showing these features, doesn’t mean that it explains what happened in the real world after the housing crash. But Scott seemed to think that the Austrian story was internally contradictory, so I’m showing that it’s not.

  22. Gravatar of johnleemk johnleemk
    28. April 2009 at 15:40

    ketzerisch:

    Yeah, that’s the sensible Austrian view (well, in my opinion) — but a lot of self-proclaimed Austrians I know want the Fed abolished right now, and reject the idea that monetary policy can ever be of good use.

    In my somewhat wishy-washy view of things, I think it’s obvious the Fed has far too much discretion at the moment, and arguably is insufficiently independent from private sector pressures. But I think that just calls for a revamp of American central banking, as opposed to its abolition. For example, what’s wrong with the New Zealand approach, where their central bank’s only job is to follow a fixed rule?

    By the way, Scott, an idea for a post: how about comparing central banks across the world? Maybe there are structural/institutional problems with how the Fed is run which we could tackle by looking at how different countries/territories run their own monetary authorities.

  23. Gravatar of Bill Stepp Bill Stepp
    28. April 2009 at 17:17

    Re: Hayek, don’t forget that he changed his view again in the 1970s when he became a free banker (“Denationalisation of Money”). Free bankers think that central banks and fiat currency should be replaced by free banks and free market money. This would consign the business cycle to history, more or less.
    Of course, the State–”the biggest mass murderer, armed robber, enslaver, and parasite in all of human history,” in the immortal words of Murray Rothbard, couldn’t finance its mass murder campaigns (a k a wars) and its corrupt amd morally hazardous welfare state.

    Monetary policy was way too loose in 2003-4 when Easy Al took the Fed funds rate to 1%. That’s what blew up the bubble. It wasn’t just in housing either. Stocks and bonds were overvalued, as was private equity (and especially its LBO component). Commodities were overvalued too (e.g., oil’s runup to $147/barrel). Even the art market experienced a bit of a bubble.

    The problem with central banking is the same problem with socialist planning in any other market–socialism in the provision and “control” of money comes a cropper on the shoals of economic reality. Hayek (and Mises) were right on this question too.
    Questions of macroeconomic coordination and economic calculation were never raised by either Keynesians or monetarists, as far as I am aware.

  24. Gravatar of TGGP TGGP
    28. April 2009 at 17:30

    Garrison’s Keynes & Hayek power-points are quite good and I think refute a vulgar Austrian commenter at the AE blog who insists we should all settle for prose.

  25. Gravatar of Winton Bates Winton Bates
    28. April 2009 at 17:35

    Re question 3, Hayek argued in “The Denationalization of Money” that “A stable price level … demands … that the quantity of money (or rather the aggregate value of all the most liquid assets)be kept such that people will not reduce or increase their outlay for the purpose of adapting their outlay for the purpose of adapting their balances to their altered liquidity preferences”. Steve Horwitz acknowledges that Hayek is arguing that “the monetary authority ought to adjust the supply of money so as to head off a scramble to obtain, or rush to get rid of, money balances” (“Microfoundations of Macroeconomics”, p 79).

    Steve also writes: “Ideally, we would like to have a monetary regime that could track changes in velocity, but without both the lags and threat of political influence associated with discretion” (p 209). I imagine that you would agree with that, Scott? The point where Steve differs from you, I think, is in his assessment of the time it takes for the monetary authority to be able to recognise that velocity has fallen (p 208).

  26. Gravatar of Bob Murphy Bob Murphy
    28. April 2009 at 18:11

    I posted my lengthy answers here.

  27. Gravatar of moldbug moldbug
    28. April 2009 at 18:36

    0. I should start by pointing out that asking Austrians what went wrong with the New Deal financial system is a little like asking a BMW mechanic what’s wrong with your Harley. His weird Teutonic perspective may be useful in a pinch, but at a certain level he’s always going to want to tell you that the problem is: you bought a Harley.

    Professor Sumner, the problem is: you bought a Harley. About 75 years ago, to be exact. Since then it has gone through six pistons, two engine blocks, nineteen belts and five clutches, not to mention leaking so much oil that once you had to call animal control because a sabertooth tiger got stuck in your driveway. It is a beautiful bike, and you have put a lot of money into it. But isn’t it time to consider a reliable German machine?

    Just as the basic problem with a Harley is the belt drive, the basic problem with the New Deal system is that it’s a soft-money design. If everything is perfectly adjusted, it may work fine. Otherwise, the belt will slip, and you’ll have a financial crisis. Austrian economics is hard-money economics – the shaft drive of monetary systems. A shaft drive doesn’t slip, and a hard-money financial system doesn’t have bank runs or business cycles.

    Which may sound attractive, if you believe it. But even if you do, it is not a useful exercise to ask the BMW mechanic how you can take the belt drive off your Harley and replace it with a shaft drive. First, his best guess is that it’s impossible, and he’s probably right. “The problem is…” Second, even if he’s wrong and it is possible, he’d have to be a Harley mechanic to know.

    That said, my answers. Bear in mind, they are derived from my own reading of Mises and may not reflect orthodox LvMI doctrine.

    1. An easy way to think of GDP is to mentally consolidate all the businesses whose net sales it counts, aggregating their balance sheets into one Stalinist megacorporation – call it Acme. GDP is Acme’s revenue. This equals Acme’s sales, which equals the demand for its goods at Acme prices. Ie, our good friend “consumer demand.”

    (Obviously, I have my amateur Harley-mechanic hat on – Austrians are not very interested in these kinds of aggregates.)

    Consumer demand – demand to exchange dollars for consumer goods – fell because the supply of dollars in the hands of consumers fell. This happened through two paths, although the two are in a sense the same.

    Path one: because of the banking crisis, the demand to exchange present money for consumer-written promises of future money (ie, to lend) dropped sharply. Thus, fewer consumers could sell these promises for dollars, as many of them had been accustomed to do, and thus they had fewer to spend.

    Path two: because of the banking crisis, the present-dollar price of many securities that consumers held (directly or indirectly) as financial assets (ie, dollar substitutes) dropped sharply. Since the demand schedule of most consumers is determined by the total market price of their assets rather than their maturity or other financial structure, this “reverse wealth effect” reduced consumer spending.

    Thus both these causal paths trace back to the banking crisis. Or, to be more precise, the run on the “shadow banking system.” The SBS was a system by which swashbuckling, amoral free-market capitalists used structured securities to replicate the characteristic malfunction of soft-money financial systems: “borrowing short and lending long,” ie, balancing short-term liabilities with long-term assets, ie maturity transformation.

    The classic example of MT in the classical banking system is fractional-reserve banking, in which “deposits” (actually automatic-rollover zero-maturity loans) are backed by long-term promises such as a mortgage. In the shadow banking system, the mortgage might have been backing a “commercial paper” note with 90-day maturity. Considering that your mortgage is a 30-year payment stream, same dif.

    By backing short liabilities with long assets, you transmute demand for 2009 money into demand for, say, 2019 money. This artificially lowers the yields and raises the price of bonds maturing in 2019. But since those who exchange present dollars for bank “deposits” or other short-term loans would not actually be willing to exchange them for 2019 bonds “held to maturity,” the scheme is unstable and tends to collapse.

    This may seems like a delicate and ephemeral concern, but it isn’t. The amount of actual demand for long-term promises of future money is a tiny fraction of the amount of artificial demand created by MT. Thus, the giant pyramid of debt that was built up in the last 25 years would drop precipitously in price if MT collapsed across the entire system.

    By introducing a quantity of spurious demand that not just distorts prices but dominates them, MT is basically a market-manipulation scheme in the money market. You can bid anything up with spurious demand, but for a round-trip profit you must “bury the corpse” and sell. Hence the bank run, in which the true structure of maturity preference reveals itself – the Hayekian price signal bursting through the noise, as it were.

    Of course, the explosion can be dramatic. If FDIC were shut off and M0 were frozen, what would bank deposits recover? Ten cents on the dollar? Five? Now there’s some deflation for ya. (Yes, there are a lot of reserves at present. But depositholders are not the banks’ only creditors…)

    We can see this price distortion easily in the “toxic assets,” for which MT has collapsed and the only demand at present comes from genuinely patient vulture investors, who are actually willing to hold these securities to maturity. While it is impossible to compute the risk-free interest rate on toxic assets, because there are no risk-free toxic securities, it may well be north of 20%.

    This price distortion in bond yields is the source of the famous Austrian “malinvestment.” A malinvestment is a long-term investment that is only profitable when financed at a yield created by MT – eg, the 5-year bonds you sold to build your semiconductor fab were financed by 30-day commercial paper, or at least financed in a market where 30-day demand was being MT-ed into 5-year demand.

    However it happened, you got a 6% rate and your fab was profitable. When MT collapses, only 5-year holders buy 5-year bonds, and the 5-year rate is now 26%, your fab she is not so profitable. Capisce?

    As Greg Ransom says, FRB and other forms of MT completely disrupt your price system, and in specific prices of future promises of money (ie, interest rates). Why not just take arsenic? It’s no less deadly, and much quicker.

    When it comes to devilish devices made by man’s ingenious hand, maturity transformation takes no back seat to the guillotine, Windows Vista, or the belt drive. Some describe it as a Ponzi scheme. It is not a Ponzi scheme, but in the long run it may be even more diabolical.

    The entire purpose of all this soft-money rubber-dollar fiat currency, at least in the New Deal financial system, is to provide completely reliable MT insurance. In the bad old days of the gold standard, banks that wanted to back present liabilities with future assets, even central banks, had to assess their “gold cover” – generally less than 100%.

    MT is a Rube Goldberg contraption even with paper money, but on a gold standard it is downright lethal. In 19th-century references you will sometimes see a bank run described as a “shortage of money,” meaning of course that the peg between specie and current promises of specie has broken – the market having noticed that there is a lot more of the latter than the former.

    So, if we skip all the proximate causes and head back to the ultimate cause: GDP fell because you bought a Harley. Now, why did you buy a Harley? A fascinating question, but here we leave the economics department.

    2. Yes.

    However, note that pouring oil into your Harley is not a fix for its oil leak. By “expansionary monetary policy,” what I think you mean is that USG should buy, directly or indirectly, promises of future money, with dollars that it prints (ie, creates by “expanding the Fed’s balance sheet.”)

    Since it can print an unlimited number of dollars, it can drive interest rates as low as it wants, and it can make up for any collapse of MT demand. It may not have the legal authority to fix the present problem, but it has the physical power to do so. Note that under a gold standard, this would not be the case.

    The process of guaranteeing rather than buying loans, which is the normal way to protect an MT scheme, is especially insidious because of its covert nature. With its printing press, the Fed can peg anything to a dollar – from a dollar’s worth of Citibank deposits, to a dollar’s worth of goose turds. And how many goose turds is that, exactly? However many the Fed wants it to be. By promising credibly to exchange a dollar for each goose turd, it also ensures that it never has to do so – the goose turds will just circulate.

    So, yes, this means is adequate to produce the desired effect. With two caveats.

    One is that all guaranteed MT systems can be equated to systems of direct government lending. System A: you lend a 2009 dollar at zero term to Citibank, Citibank exchanges that dollar for $1.50 in 2019 mortgage payment dollars, FDIC guarantees your loan to Citibank in case MT collapses. System B: you lend a dollar to FDIC, FDIC lends a dollar to Citibank, Citibank exchanges it for 2019 mortgages. System C: you lend a dollar to FDIC, FDIC exchanges it for 2019 mortgages. System D: you keep your dollar; FDIC prints a dollar, and exchanges it for 2019 mortgages.

    All these systems are identical at the end-to-end level. And all of them depend on FDIC’s privilege to print money. Frankly, I prefer System D. It’s simpler. It is what it is. It’s bold and proud, and it has nothing to hide. (System D was also the practice, until recently, of the Zimbabwean Reserve Bank.)

    So this is our first caveat: are you trying to keep this crazy scheme going, or are you trying to shut it down? Do you actually think USG should be printing money and lending it? Does this strike you as healthy, normal, and sane? If so, you may be a “progressive.”

    As for the second caveat, note the Zimbabwean example. Why do people demand your currency? Your dollars, goose turds, or what have you? Well, partly because they have $83 trillion dollars of debt they owe in the damned stuff, but partly also because the poor saps use these instruments as “money” – ie, goods that can be held to transfer present demand into the future.

    Ie, currency is more than just a medium of exchange – it is a medium of saving. Monetary demand seeks out the most effective such instrument, ie, the one which is most likely to appreciate, counting storage costs etc, over the holding period.

    If you actually adopt Silvio Gesell’s crazed scheme of negative interest rates, which is equivalent to a high storage cost, you can expect the market to go looking for a more effective medium of saving in a hurry. No prizes for guessing what that medium might be. And that’s when we get into serious Latin American territory.

    I like to think of fiat currency as sovereign equity. The parallel is not exact, because a dollar of course confers no right to change USG’s management, and nor does it pay any dividend. On the other hand, you could say the same of Google stock.

    Google, however, is a well-run company and does not dilute its equity (ie, issue new shares – the equivalent of “printing money” – unless it actually needs to. A sovereign which is continuously diluting its currency looks a lot like a failing corporation in an equity-dilution death spiral. And it ain’t a pretty sight, let me tell ya.

    3. The question is both pejorative and misguided.

    First, Austrian economics is a methodology, not a cult. It makes no difference what Hayek would or would not have thought. Anyone can use his methods and arrive at his conclusions.

    Second, if Austrian economics was a cult, its Jim Jones would be Mises, not Hayek. Hayek was a student of Mises, and most people only know his name because he won the Swedish Central Bank prize. He was not selected by Austrians, he was selected as a token Austrian who still had some friends at the LSE. Mises and Hayek seldom disagree – but when they do, Mises is canonical.

    4. See #3.
    5, 6, 7: See #2.

  28. Gravatar of johnleemk johnleemk
    28. April 2009 at 21:31

    Bill Stepp, states were financing tyranny before fiat money was really viable. Seignorage is relatively unimportant in most modern states as a source of public financing. I also find it extremely difficult to believe that the Fed is the sole cause of the business cycle. (*A* cause, yes; an important cause, maybe; but *the* cause?) As far as I can tell, economies have had booms and busts before fiat money was a twinkle in some tyrant’s eye.

    Moldbug, while I can see where you are coming from, an issue I’ve often had with the notion of free banking/commodity standards is that it seems to me fractional reserve banking would still be present. Fractional reserve banking started up as a financial innovation around the 1800s, and I can’t think of a way to get rid of it without government regulation of the financial markets specifically outlawing the practice — and even so I am confident some financiers would find ways to avoid the spirit of the law while hewing to its letter. I don’t see how changing from fiat money to something else would tackle this problem, assuming it is a problem.

    Also, a minor nitpick: I believe it is the Federal Reserve which prints money. The FDIC just insures bank deposits and reorganizes failed banks.

  29. Gravatar of Bill Stepp Bill Stepp
    29. April 2009 at 02:01

    While it’s true that the State financed tyranny before it gained control of the money supply, real tyranny didn’t begin until the beginnings of central banking. The government bond market was created to finance mass murder.
    Business cycles existed before central banking, but they were generally shorter and sharper. Business cycles since the creation of central banks have been longer and deeper.
    According to George Selgin, 7 of 41 business cycles happened under free banking; the others happened under central banking.
    Case against central banking closed.
    The printing press in Washington that actually created Federal Reserve notes is owned by the Treasure, I think.
    As a kid I went on a trip there and we toured the place.
    Little did I know it was a criminal enterprise.

  30. Gravatar of ssumner ssumner
    29. April 2009 at 08:08

    As you may have noticed, I am way behind in getting to these comments. I did add an update at the end of my post (about a page long) which gives my view on some Hayek info that people like Bob Murphy, TGGF, and others whose names I forgot had sent me. I don’t plan any new posts for a while, so maybe we can keep the conversation going.

  31. Gravatar of JimP JimP
    29. April 2009 at 08:46

    Wanna bet ?

    Its 30 min till the Fed announcement.

    Whats the odds they will announce:

    1. We are going to stop paying interest on excess reserves and start charging interest on them.

    2. We will have a committed price level target – prices in the U.S. will be x% higher y years from now – and we are the Federal Reserve so we can do that – and we will.

    I bet they wont announce this – and we are stuck in the Bernanke deflation till we roll over and die.

    Any takers?

  32. Gravatar of moldbug moldbug
    29. April 2009 at 09:01

    Johnleemk,

    A good question. While I agree with Selgin and the heretical “free banking” Austrians who believe that FRB/MT contracts need not be fraudulent, I also don’t really think it matters. The practice will not exist in a free market not because it’s illegal, but because it’s imprudent.

    It’s not hard to see why MT is imprudent. Again, when you practice MT, you’re buying into a market-manipulation scheme. You should expect to get pwned. Let’s see how it happens.

    The easiest way to see the imprudence is if we lose the banks or other intermediaries, and do our MT directly. At least in an ideal financial system, MT does not require an intermediary. Wherever you would have held cash, just hold 10-year Treasury strips instead. When you want to actually buy some good, exchange the Ts for cash and the cash for your good.

    A 10-year Treasury strip (ie, zero-coupon bond, ie, 2019 dollar) is “illiquid” in the sense that its maturity is far in the future, but “liquid” in the sense that it trades instantaneously with negligible bid-ask spread. (This ambiguity is the best reason not to employ any conjugation of the L-word. Eg, don’t say “maturity preference,

    Why would anyone do this? Because 2019 dollars appreciate over time. In 2009 they may trade for 65 cents, but in 2019 they’ll go for $1. 2009 dollars do not share this wonderful property – they stay dollars. So why hold 2009 dollars, when you could hold 2019 dollars?

    And indeed, if you’re the only one doing this, it’s a great idea. The problem is that it is not a Nash equilibrium – if you are part of a herd which is all doing this, it is no longer a prudent strategy. The prudent investor will avoid strategies that are not Nash equilibria. He can be confident that whatever he is doing, he is not the only one doing it.

    If you are part of a maturity-transforming herd, no intermediaries are needed to replicate the classic bank run. The herd of people whose actual demand is for 2009 dollars, but who are playing with fire by holding 2019 dollars, has driven up the price of 2019 dollars. (Ie, they have driven the 10-year interest rate down.) They have created a feedback structure which amplifies any withdrawal in the opposite direction. Just as in any bubble.

    So (just for one example), if there’s a flu pandemic and everyone has to spend their 2019 dollars all at once on respirators and canned food, they all have to rush for the same exit – 2009 dollars. The result is that yesterday, your 2019 dollars were quoted at 65 cents, but today they seem to be trading at 25 cents. But you need to sell anyway. D’oh! You’ve been pwned.

    The best analogy is to Ponzis. MT is not precisely a Ponzi scheme (I have attempted, unsuccessfully, to propagate the phrase “Bagehot scheme”), but obviously it can produce remarkably similar outcomes.

    If you buy into a Ponzi scheme, you should expect to be pwned. And same with a Bagehot scheme. Whether the Nanny State should, or should not, protect its kiddies from this sort of pwnage (in the absence of fraud per se, ie, misrepresentation) is a matter of philosophy, not economics.

    On an off-topic note, Laurence Kotlikoff seems to have figured this stuff out. Unfortunately, he gives credit for the discovery that “borrowing short and lending long” is a bad idea to – of all people – Irving Fisher! Perhaps some angry emails from Austrians would set him straight.

  33. Gravatar of moldbug moldbug
    29. April 2009 at 09:02

    As for the nitpick: FDIC’s connection to the Fed’s printing press is informal, but no less real for it. If there was any actual suspicion that FDIC did not have an infinite credit line, the mother of all bank runs would happen instantly.

  34. Gravatar of moldbug moldbug
    29. April 2009 at 09:04

    Broken sentence above: I meant “don’t say liquidity preference, say maturity preference.” Eg, the demand to hold 2009 dollars rather than 2019 dollars.

  35. Gravatar of JimP JimP
    29. April 2009 at 09:29

    And the answer is:

    They did zip.

    Stunning.

    “Some risk that inflation could remain low”

    Again – giving us THEIR miserable and sad expectations – rather than SETTING ours – in a positive direction.

    Stunning.

  36. Gravatar of JimP JimP
    29. April 2009 at 11:07

    Falling NGDP:

    http://www.economist.com/blogs/buttonwood/2009/04/more_than_real.cfm

    And what does the Fed do? Tell us today that they expect it to continue.

    Charming

  37. Gravatar of fundamentalist fundamentalist
    29. April 2009 at 11:28

    Here’s my two-bits:

    1. Why did NGDP collapse late last year?

    I tend to prefer Hayek’s explanation of the business cycle in his “Profits, Interest and Investment.” The collapse begins when high profits in consumer goods make labor cheap relative to capital, so businesses employee more labor and less capital equipment. This is Hayek’s Ricardo Effect and micro econ 101. This causes demand for capital equipment to fall, while at the same time the shortage of capital goods causes prices of inputs to rise in the capital goods industries. Higher costs with lower demand squeeze profits in the capital goods sectors and many businesses fail while others lay off workers. This slow down in capital goods production doesn’t show up in NGDP figures because GDP is weighted toward consumer goods. However, when workers lose their jobs in capital goods industries, such as autos and housing, they buy fewer consumer goods and NGDP falls.

    2. Could a suitably expansionary monetary policy have stopped NGDP from collapsing?

    Probably not. It might reduce the depth of the fall, but many things are working against it. 1) A lot of wealth gets destroyed in the boom and people want to save to rebuild that wealth. 2) NGDP during the later stages of the boom was unsustainable because there weren’t enough capital good to sustain it. 3) Credit shrinks as people get scared and pay off debts. The boom required unsustainable levels of debt. Lower levels of debt require a lower NGDP. The Fed is not all powerful. It can’t force businesses to borrow. Greenspan called it pushing on a string.

    3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

    It seems so. In PII he makes a similar argument because he feared that letting profits in the consumer goods industries fall too low would cause too much investment in capital goods. However, the dangers are that the money will go to the wrong places (to speculation instead of production or to the wrong industries) and that the Feds will keep up the monetary pumping too long and ignite another bubble.

    “What I am basically asking here is if the housing bubble was the problem; shouldn’t there have been enough NGDP growth to support the non-housing parts of the economy, while allowing housing to decline as necessary?”

    Housing was just one of the most obvious areas of malinvestments. Overinvestment in the auto industry was a problem for many years. Also, housing isn’t isolated. Housing is directly tied with commodities, appliances, furniture, etc. Like a sewer, problems in housing back up into all of the feeder industries. In addition, the collapse in credit affects all businesses that have too much debt, regardless of the industry they’re in.

    “I don’t think investment exceeds saving during the boom.”

    Ex-post it can’t, but it can ex-ante. If investment did not exceed savings ex-ante, then there would be no shortage of capital goods and no excess consumption and therefore no Hayekian business cycle.

  38. Gravatar of Devin Finbarr Devin Finbarr
    29. April 2009 at 14:33

    Moldbug-

    I think you are on the mark with everything you say about maturity transformation. But I’m not sure that justifies getting rid of it.

    I was reading Bagehot’s Lombard Street recently. One of the points he drives home is that the Anglo fractional reserve system allowed a far greater amount of credit than any other system. This credit funded the factories that created the industrial revolution. A lingering question of history is why did the industrial revolution start in England. Perhaps part of the answer is that England’s maturity mismatched banking system allowed an usually amount of long term lending to occur.

    What if fractional reserve is the accidental fraud that created the industrial revolution? So yes, a fractional reserve system can be modeled as a system where savers are taxed to subsidize credit. But what if that’s a necessary component of break out economic growth?

    Imagine an economy where innovators have trouble reaping the full rewards of their inventions. In this economy, the typical credit funded business has a far greater consumer surplus than producer surplus. Perhaps an innovator sets up a textile factory with a new type of loom, only to have everyone else copy his techniques, so that he never profits.

    In a non-MT system, bankers and investors may never fund this factory since they will not reap the benefits.

    In an MT system, holders of dollars are essentially taxed to subsidize credit. As a result, investment in the new textile factory is now profitable. The factory produces so much consumer surplus, that clothes become much cheaper. So even though the savers of dollars had their dollars diluted, they still win because the purchasing power of their dollars has increased.

    Empirically, there seems to be a lot of evidence that the above is what happened. The Bagehotian system may be a rube goldberg contraption, but its the only banking contraption that produced an industrial revolution. That’s got to count for something. You also notice with other financial bubbles. The internet bubble was a total bust from the perspective of investors, but in terms of total consumer surplus and the purchasing power of dollars, it may have been an overall win.

    I do agree that it would be better if the government was more honest about the process. But as you know, as long as we live in a democracy, dishonesty is a part of policy. And until your blog posts start circulating in the upper echelons of the military, democracy is what we’ve got.

    So rather than ripping out the banking system that produced the industrial revolution, and doing the always dangerous total rewrite, perhaps the prudent thing to do is just patch the current system. ( Eliminate the limits on FDIC insurance, convert the money market funds to FDIC insured bank accounts, tighten up the credit rating process, limit the amount of MT so the dollar dilutes at <5% a year, etc., etc.)

  39. Gravatar of ssumner ssumner
    29. April 2009 at 15:51

    I will start with the first bunch of comments, and work forward.

    Joe, I don’t see why a need to rebuild savings causes NGDP to fall, unless the central bank is incompetent.

    And why “manufacturing overcapacity in Asia?” Isn’t the problem too little demand for manufactured goods made in Asia. There are still lots of poor people in Asia, the constraint on Asia’s growth is (should be?) on the supply side. So if factories are idle and prices are falling, I’d say they should ease monetary policy. Lack of AD should not be holding back Asia’s growth right now. If America doesn’t want to buy their shoes, I’m sure there are lots of Asians who would, if their had the money.

    Ketzerisch, Yes, I agree that we need to assume the Fed will be around for at least a while. That’s my working assumption so I don’t pay much attention to people who say abolish the Fed. Especially people who tell me we’d magically had stable money without the Fed, even though the price level fluctuated up and down even before the Fed was founded.

    Greg, Yes, I like Hayek’s later views better.

    Jon, That’s a good idea. But let me make a slight correction. I don’t exactly talk about a zero inflation rate environment. Rather it is a commodity standard/zero expected inflation environment. Your analysis suggests something almost like the natural rate model. If a commodity standard anchors the price level, then monetary disturbances that push up prices are inevitably offset by later downturns. So the gold standard may have contributed the development of Austrian econ (as I argued it did with Keynesian econ.) In my Depression manuscript I argue that Austrian views of the late 1920s, which make no sense from a Friedman and Schwartz fiat money approach, suddenly make a lot more sense if you remember policy was constrained by the gold standard.

    Ketzerisch#2, Yes, I agree that U.S. output needs to rise, but so does world output. China alone needs at least 10% real growth, and with better economic policies they could get 12 or 13%. On the question of the Fed controlling long term interest rates, that’s half true. It is true if you remember that tight money (1929-33) lowers long rates and easy money (1970s) raises long rates. Most people forget that point. And obviously it is an important point. Right now money is really tight.

    Greg, Good summary of Austrian econ, and I also agree with some of the points. However, I disagree about NGDP, I think monetary policy could make it go up indefinitely. Another Austrian named Bob Murphy mentioned the Zimbabwe example when I asked in the Fed could prevent NGDP from falling. Another example is how some developing countries used to run chronic inflation of 20-50% a year to finance government. If you want to do things that way, you can make NGDP go up forever. Of course my preference is only 5% NGDP growth, and I’d even be thrilled with Bill Woolsey’s 3%, if we could just get a stable policy from the Fed.

    My hunch is that just like Keynesian econ, there is an Austrian economics for the gold standard, and another one for fiat money. I found the Keynesians often don’t even understand that their models are contingent on monetary regimes. Do the Austrians? I say this because if you have a gold standard then your answer on NGDP makes perfect sense. So maybe you and Bob are making different implicit assumptions about monetary regimes.

    The only other issue I’ll mention is the 1927-29 expansion, the only 20th century boom that saw a falling price level. I do get the Austrian point that the slight deflation was misleading, and that you could make an argument that monetary policy was nonetheless too expansionary. But what about the scale of the policy error vs. the severity of the following down cycle? That’s what I don’t get. There have been other booms with more money, faster inflation, lower interest rates, worse policy errors by almost any criteria, and often they were merely followed by mild recessions (i.e. the 1970 recession.) So why was the fall in NGDP so steep? (BTW, I also agree with the Austrian view that real output fell more than necessary in response to falling NGDP when Hoover tried to prop up wages. But I still don’t think Austrians have a plausible mechanism for the severity of the NGDP fall.) But maybe there are explanations I haven’t seen.

    I’ll do the remaining comments a bit later.

  40. Gravatar of ssumner ssumner
    29. April 2009 at 16:38

    Gabriel, So capacity exceeds the “true demand for shoes.” But isn’t the true demand a function of AD, and thus ultimately monetary policy? Until every Asian peasant has as many shoes as Imelda Marcos, isn’t there always potential demand out there? I do understand that sectoral shifts can create a bit of unemployment–like we had in late 2007 and early 2008, I just don’t see how it gets us high unemployment. The world needs more demand. Asia is being punished for our mistakes.

    Bogdan. Of your explanations for falling NGDP, more money demand is the only one that makes sense to me, but it makes a lot of sense.
    I don’t recall if you are new to this blog, but one distinctive feature of my approach is a different view of the whole policy lags issue. I do think that although there are policy lags, central banks can instantly affect the future expected price level. My big critique of the Fed is that they let the future expected price level plunge last fall. That’s very destabilizing, whatever one thinks should be the appropriate long run inflation (or deflation) rate.

    On interest rates, I say yes as a signally role for the public and business, and no as an indicator of easy or tight money.

    Devin, I read a good bit of it, but I am pressed for time. It looked somewhat interesting, but what’s the punch line? I need to know the guy’s (Fed) policy views to figure out how much time I want to spend on his essay, which is even more long-winded than mine.

    Bill, Very good summary. Thanks. I like your point about single family homes. Just to follow up, isn’t the Austrian story much less applicable to homes than to the zillions of miles of unneeded fiber optic lines built in the tech boom? Even today, the U.S. housing stock is probably worth more than it was five years ago, and much of the housing is worth only modestly less than construction costs (land is another issue.) So hasn’t there been much less wealth destruction than in the tech boom? But why is this recession much worse (from the Austrian perspective?)

    Bob, Thanks, I enjoyed the essay. But I just can’t get by the thought that a lot of employment is being lost in industries for no good reason, indeed being lost in industries where people should be entering, not exiting. We had too much housing construction, so we should be discarding jobs in construction and adding jobs in manufacturing and services. I understand there is some employment during the transition,but why is demand for manufactured goods and services also falling? That seems to me to be a sign that tight money is slowing the needed labor movement out of housing and into other sectors.

    The rest will be tomorrow morning.

  41. Gravatar of Greg Ransom Greg Ransom
    29. April 2009 at 17:47

    Scott — I don’t know of a single “Austrian” who believes that the size and scope of the Great Depression is explained by Fed monetary policy prior to 1929. Not one. The severity of the down cycle is explained by all sorts of policy errors after the inevitable end of the artificial boom — the tariff, the anti-branch banking laws, the deflationary Fed policy guided by the “Real Bills” ideas, efforts to block wage adjustments, government sponsored cartelization, and on and on. Robert Higgs is an “Austrian” historical of economics whose done great work on the topic. Robert Murphy has a new popular book out on the topic.

    Roger Garrison has an article on his web site which talks about how the Hayekian theory explains the nature of the artificial boom and the inevitability of the bust, but doesn’t necessarily determine the size and scope of the bust, which can be greatly shaped by what the government and the central bank does in the bust phase.

    Scott writes:

    “The only other issue I’ll mention is the 1927-29 expansion, the only 20th century boom that saw a falling price level. I do get the Austrian point that the slight deflation was misleading, and that you could make an argument that monetary policy was nonetheless too expansionary. But what about the scale of the policy error vs. the severity of the following down cycle? That’s what I don’t get. There have been other booms with more money, faster inflation, lower interest rates, worse policy errors by almost any criteria, and often they were merely followed by mild recessions (i.e. the 1970 recession.) So why was the fall in NGDP so steep?”

  42. Gravatar of Greg Ransom Greg Ransom
    29. April 2009 at 17:57

    Scott — here’s Austrian Steve Horwitz on why the Great Depression was so different from standard U.S. booms and busts:

    http://www.fraserinstitute.org/education_programs/forstudents/ask_professor/Fraser_03020901.asp

    First, President Hoover responded to the crisis not by standing by and doing nothing, as the myth of him as a defender of “laissez-faire” would have it. In fact, Hoover had a long and distinguished career in government service where he consistently demonstrated a strong desire to use government to fix the problems he perceived in the market, first in the Food Administration in World War I then as Secretary of Commerce in the 1920s. In the face of the recession, he responded with a variety of government programs and policies, all of which made it that much more difficult for markets to adjust during the recession. He passed several large-scale programs to provide tax dollars to struggling businesses (including banks), raised taxes substantially in 1932, and perhaps most notoriously, convinced businesspeople to not cut their wages in the face of the ongoing deflation. The latter policy led to two disastrous results: the rapidly rising and long-lasting unemployment that we noted last month as firms could not afford to keep as many employees with wages high, and also declining corporate profits and stock prices as the higher wages had to come from somewhere.

    The second, and perhaps more important, reason things got so bad was that the Federal Reserve System allowed the supply of money to fall by over 30% between 1929 and 1933. This massive deflation was both a cause and effect of the ongoing bank failures and generally made it difficult for firms and households to get the money they needed to make mutually beneficial exchanges. As a result, both machines and people were idled, as the unemployment rates in the 20% range indicate. Milton Friedman and Anna Schwartz documented this massive failure by government in the early 1960s, but it still has not penetrated the public consciousness as high school history textbooks and popular accounts of the Great Depression rarely, if ever, mention the role played by the Fed in making matters much worse. Counterfactuals are always difficult, but had the Fed responded correctly in the early 30s, we would have had a severe recession but not the calamity we experienced.

    Bad government policy from Hoover and the government’s central bank failing to perform its task made the recession much deeper than any before. However, it took President Roosevelt to ensure that the problems lingered on for another decade …

  43. Gravatar of Jon Jon
    29. April 2009 at 19:12

    In my Depression manuscript I argue that Austrian views of the late 1920s, which make no sense from a Friedman and Schwartz fiat money approach, suddenly make a lot more sense if you remember policy was constrained by the gold standard.

    Scott: To follow-up, the commodity standard explanation reads very plain. To quote Mises in his first mention of the theory:

    If our doctrine of crises is to be applied to more recent history, then it must be observed that the banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their own part and on the part of all those who had not forgotten the earlier crises, or whether because they had to defer to legislative regulations concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. If the stress is laid upon the word postpone, then this line of argument can be assented to without more ado. Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse and the reaction against the bull tendency of the market the stronger, the longer the period during which the rate of interest on loans has been below the natural rate of interest and the greater the extent to which roundabout processes of production that are not justified by the state of the capital market have been adopted. — Theory of Money and Credit Chapter 19, Section 5, 1912

  44. Gravatar of Devin Finbarr Devin Finbarr
    29. April 2009 at 19:13

    hibida, Joe Calhoun, fundamentalist and the other deflationists:

    Consider the following scenarios:

    1) Imagine all dollar bills with even numbered serial numbers vaporize. The immediate effect is that people cut spending, in order to restore their savings to expenditures ratio. But people do not cut spending neutrally – they cut durables and luxury goods first. Thus there is a huge amount of unemployment in those industries. Eventually, the unemployment pushes wages down in industries across the board, prices drop, people can afford durables and luxuries again. The system rebalances with the exact same level of production, but all prices cut in half. But this process may take a long time, and meantime the economy suffers a catastrophic depression. The proper Fed response is to print money to replace the vanished bills. By acting quick, the Fed can avoid the depression.

    2) Imagine that years ago the money supply had been inflated with counterfeit bills. Half the money supply was counterfeit. The counterfeiting ended decades ago, but the bills have remained in circulation. The bills pass through dozens of hands hands over time. But one day people discover the counterfeiting and people refuse to accept the bills. Like in the first example, you get massive deflation and a depression. Again, the proper Fed response is to make a one time offer to replace the counterfeit bills with real bills, to avoid the deflation.

    3) Imagine that the counterfeiting is continuous. Each year counterfeiters print an amount of bills equal to 5% of the money supply. They spend the money on wine and women. Now imagine they are caught and the counterfeiting stops. As a result, many people in the brothel and winery industry lose jobs. But retirees can now spend more, because without the constant inflation their savings lasts longer. So the those who lost their jobs now find jobs in different industries. Here the proper Fed action is to do nothing. Real resources must be reallocated.

    4) Now imagine a scenario that combines 2) and 3). So you have counterfeiting over many years. The counterfeiters are found out, and the counterfeit bills are discovered. The proper action is for the Fed to stop the counterfeiters, but to replace the counterfeit bills in circulation. So there will be some unemployment in the wine and brothels sector. But there will be no general deflation and collapse of consumer durables industry.

    The classic Austrian mistake is to not realize the difference between scenario 2) and scenario 3). There is unemployment caused by stopping the inflation. This unemployment cannot and should not be avoided. There is also unemployment caused by the non-neutrality of deflation. This unemployment can and should be avoided.

  45. Gravatar of Peter Peter
    29. April 2009 at 19:30

    The Chinese (and others) have been running large trade surpluses in shoes and other things with the US for years and lending the money into the US allowing the purchase of more shoes etc. So while the potential demand for shoes is unlimited, the effective demand for the shoes was overstated.

  46. Gravatar of Jon Jon
    29. April 2009 at 20:41

    I don’t exactly talk about a zero inflation rate environment. Rather it is a commodity standard/zero expected inflation environment.

    In this context, I mean inflation in Mises sense. To wit, he writes:

    In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur.

    But yes, we mean the target is zero, not necessarily the result.

  47. Gravatar of Bill Woolsey Bill Woolsey
    30. April 2009 at 03:04

    Devin:

    Good story about the counterfeiters and the disappearing currency. Of course, that isn’t exactly what happens, and perhaps the differences are important, but it does communicate something about the initial vs. secondary depression idea. And, as Ransom never tires of repeating, Hayek recognized that. And it plays an important role in the thinking of the “free banking” group of “Austrian” economists. Perhaps some of the amateur economists on the net who have been influenced by the Rothbardians will understand.

  48. Gravatar of Thruth Thruth
    30. April 2009 at 05:08

    Following on from Devin and Bill:

    So if you then believe that the Fed is constrained at a zero bound (for political or other reasons) then you open the door to Keynesian stimulus as crude monetary policy? (I’ve heard both Michele Boldrin and Bob Lucas concede this point)

  49. Gravatar of ssumner ssumner
    30. April 2009 at 05:17

    Johnleemk, That’s a good idea, but I don’t know much about foreign central banks. Also remember that they face different issues, most do not influence world AD, which the fed clearly does.

    Bill Stepp, Not only were there cycles before the Fed was created, but that were at least as bad as the cycles since we went off the gold standard. (1982-2007 was the most stable 25 years in U.S. history.)

    The Federal government could easily finance itself without the Fed. 99% of its revenues come from taxes, not money creation.

    Easy money didn’t blow up any bubbles, perhaps low real long term interest rates did, but that has nothing to do with the Fed.

    TGGP, Thanks, I responded in my update above.

    Winton, Then Steve Horwitz should agree with me. Aaron Jackson and I published a paper arguing that with velocity futures there is no need for structural models of the economy. Isn’t that what Austrians want? Don’t they want the market to determine the money supply, not models thought up by MIT professors? Futures targeting gets around the lag problem.

    Moldbug, I don’t see how financial problems that destroy wealth and lead to less consumption would cause NGDP to fall. Zimbabwe has had lots of problems, and I’m sure consumers are tightening their belts (because of famine, literally tightening their belts), but their NGDP soared. So I don’t buy your explanation.

    You say a fiat money system might work if well run, hmmm, that sounds a lot like a gold standard. Remember the gold standard of 1929-33?

    I don’t understand all your talk about interest rates. First of all, are you assuming the Fed determines interest rates? If so, you lose me right there. When the Fed tightened policy in December 2007 interest rates fell. Neither Keynesians or Austrians have a good explanation for that fact. Ratex economists do.

    JimP, Thanks for the link. By the way, did the Fed’s really claim we had 3% inflation in the first quarter? That’s absurd!

    Fundamentalist, Like many others here you are giving me a real explanation for a nominal variable. Of course they can prevent NGDP from falling, look at Zimbabwe.

    I thought the distinction between ex ante and ex post saving was a Keynesian idea. Do the Austrians also use it?

    Moldbug2; I don’t see any evidence that maturity transformation has anything to do with the modern business cycle. I explains neither supply shocks, nor demand shocks. In my view demand shocks are caused by monetary policy moving NGDP up and down unexpectedly. That can occur just as easily in an economy with no banks at all. I don’t believe the financial system plays an important role in modern business cycles. Changing NGDP and sticky wages explain it perfectly well.

    Devin, I agree that we need to stick with MT, but I think we need to go the other way, gradually phasing out FDIC.

    More to come . . .

  50. Gravatar of Bill Woolsey Bill Woolsey
    30. April 2009 at 05:26

    In my view, the Austrian trade cycle theory is a confused understanding of the public finance elements of money creation. An old paper in the Journal of Libertarian Studies (I think) by Richard Wagner pointed me in this direction.

    In standard neo-classical macroecnomics, particularly the “monetarist” version, inflation is a tax on real money balances, generating a revenue which we call seignorage.

    Public Choice economists (including Wagner) generally follow Buchanan in considering that taxes are imposed because somebody wants the revenue for some purpose. There is a tax and spending program with the political system (voters, politicians, etc.) trying to accomplish something. While financing true public goods is a possiblity, transfers are equally possible.

    Wagner’s point was that from this public finance perspective, the notion of “neutral” inflation is a bit absurd. Of course inflation impacts the allocation of resources. That is the point.

    If we think about some basic principles of public finance, and really just supply and demand, then generally, elasticities of supply and demand are less in the short run than in the long run. If we imagine a constant tax rate, then the revenue from that rate will be greater when it is first imposed and then lower as adjustments are made. Carry that over to the use of the revenue, then given a constant tax rate, the amount of goods and services that can be obtained will first be larger, and then smaller.

    The “laffer curve” idea follows from simple supply and demand. What is the tax rate that provides the greatest revenue? Higher rates raise revenue from a given base, but higher rates lower the base. And a lower base lowers revenue. What rate, taking into account the impact on the base, generates the most revenue?

    That, of course, is the tax rate that will give those spending the revenue the greatest impact on the allocation of resources–producing things they want. (Think about the laffer curve for a excise tax–on beer for example–and not the income tax. It is the same basic idea, but really, the laffer tax took something obvious about an excise tax an applied it to income in a simple minded way.)

    Put the short run and long run elasticities idea and the laffer curve ideas together, and then we can see that in the short run, a tax may provide a revenue and command of goods and services that isn’t feasible in the long run. Attempting to raise tax rates to increase revenue to what had been obtained at the lower rate will simply result in less and less revenue. You are on the unfavorable side of the laffer curve. Raising rates ever more to try to maintain a command of goods and services that was actually obtained in the past eventurally results in a zero base and no revenue.

    Apply all of this basic public finance to the inflation tax on real money balances. Further, suppose that the revenue is used to subsidize the production of capital goods, lending, borrowing, or something along those lines.

    There are important equilibrium impacts on the allocation of resources. Many Austrian economists are libertarians (like me.) They don’t like any taxes. Being from the Virginia School and a somewhat moderate libertarian, I prefer taxes that are obvious to taxpayers. Having the entire private sector raise prices and requiring that people reduce their real expenditures to maintain their real money balances is not what I count as a transparent tax.

    Anyway, there is a tendency in Austrian trade cycle theory to confuse equilibrium impacts of the inflation tax on the allocation of resources that are “bad” because all taxes are bad or else the inflation tax is in particular bad, with disequilibirum effects. A given inflation rate should be expected to provide more revenue before elasticies adjust than after. You could start with the inflation rate low and then raise it to maintain a constant real revenue stream. This could cause problems.

    It is possible to obtain a larger real revenue stream in the short run that will not be available in the long run. In my view, the Austrian Trade cycle theory focuses on this special case.

    So, we can imagine changing the inflation tax rate. If we focus on the favorable side of the laffer curve, then it changes generating more or less revenue in the usual way, and it impacts the allocation of resources. If the inflation tax were earmarked to the purchase of tanks, then this would be kind of obvious. It it was used to pay a subsidy to apple farmers, so that the relative price of apples was lower (while nominal apple prices and every other price were rising,) it would seem a bit more strange. Because it is sometimes earmarked to an odd subsidy scheme that works though credit markets, it is not always so obvious at all. A variety of durable consumer goods and capital goods are being subsidized.

    The important thing to remember, is that a variety of inflation rates are feasible in the long run. And that the view that this tax is bad and should be abolished doesn’t mean that the allocation of resources given the tax is a disequilibrium allocation. (No more that the impact of a tax on cigarettes used to fund medicaid is “disequilibrium.”)

    This equilibrium impact of inflation on the allocation of resources (even if it is “bad” tax policy) should not be confused with disquilibrium impacts caused by changes in elasticity. With prefect foresight, there isn’t going to be any malinvestment. Realisticly, there may well be some, but in my view, many Austrians confuse the equlibrium impact with the disequilibrium that is just the same thing as the difference between short run and long run elasticities in any market, but applied to real money balances.

    But the real problem with Austrian trade cycle theory is that for some reason, they especially focus on the special case where the real revenue generated in the short run is in the region between the revenue maximum points of the long run and short run laffer curves as applied to the inflation tax.

    So, it isn’t just that the inflation tax is a “bad” source of revenue and that either there should be no taxes or else some other, more transparent tax should be used. It is rather that any effort to use the inflation tax will generate an unsustainable allocation of resources. And stories are told that amount to raising the inflation tax ever higher beyond the point of the long run maximum revenue.

    If we imagine that the “target” is the interest rate, the inflation tax can be used to subsidize credit markets so that the equilibrium interest rate is lower. (Really, it is a drop in the natural interest rate.) But, suppose this
    subsidy is used to lower the interest rate to a point that cannot be maintained in the long run? One obvious possiblity is that we assume the central bank pushes down interest rates as far as it can in the short run (when elasticities of money demand are low.) Suppose that in the back of our mind, we are assuming this is just about zero! If the central bank takes this target that is not feasible in the long run, and tries to maintain it by ever increasing the inflation rate, then we get to hyper inflationary collapse. This is the 100% tax rate where the base is supposedly zero on a simplistic laffer curve. Obviously, 100% inflation doesn’t result in zero real balances. But my point is that Mises’ collapse stories are about raising the rates ever more to maintain revenue until the base falls to zero.

    Similarly, if you think about maintaining the allocation of resources, you get the same impact. If your target is maintaining the allocation of resources that reflects a level of revenue that is unfeasible in the long run, and you raise the inflation rate to do this, then you get to a collapse in the base–real money balances.

    Consider the following story. We target an allocation or resources or an interest rate that is unfeasible in the long run. To begin with, the elasticity of the demand for money is very low, so only a modest inflation rate is necessary. As elasticity rises, the same revenue requires a higher inflation. Eventually, you get to the point where efforts to increase the inflation rate even more are counterproductive. The interest rate rises and/or the allocation of resources are shifted back.

    Anyway, if instead, the central bank is targetting the inflation rate, and has been doing some for a long time, then any malinvestents are long past. We just have an allocation of resources that reflects a tax on real balances, whose revenue is used to subsidize credit markets. Of course it impacts the allocation of resources.
    If it were earmarked to tanks, this would be obvious. If it was an apple production subsidy, it would be clear enough.

    In the real world, I think the meta-story is that we were in a high inflation tax world and then went to a low inflation tax world. The resulting change in the equilibrium allocation of resources are long past. The 2% inflation world we have now is not generating “malinvestments” any more than building a medicaid clinic to take care of clients whose bills are paid with funds from the cigarette tax is a malinvestment. However, if we imagine that the client list was very large because there was lots of revenue and that as people quit smoking and the revenue was reduced and they hand to tighten elibility and so there were fewer clients, then maybe a clinic that was profitable in the begining would be unprofitable later. Like Cowen and Caplan, I think it is obvious that this was an entrepreneurial error on the part of the clinic owner. Your sales are based upon a tax revenue stream that depends on cigarette purchases and that higher taxes are going to cause people to smoke less. But, I wouldn’t be surprised that such an error might occur. What I see as the problem with the Austrian Trade Cycle theory is that it ignores that maybe the clinic would be profitable in the long run, and, further, that certainly some expansion in the capacity of health care provision would be profitable because Medicaid is receiving funds from the cigarette tax.

    So, changes in the monetary regime imply a change in the allocation of resources that may look a bit like an austrian trade cycle theory if we move to lower inflation rate regimes. (Despite that, I favor moving to a zero inflation rate regime — just not right now.)

    Errors in the operation of the regime almost certainly impact the allocation of resources. If anyone purchases durable goods on the assumption that these temporary changes are permanent, that is an entreprenial error. It wouldn’t surprise me that such things happen. But that shouldn’t be confused with the different allocations of resources implies by the normal operation of the different monetary regimes. And that is the key error of the Austrian Trade Cycle theory.

  51. Gravatar of ssumner ssumner
    30. April 2009 at 05:40

    Greg, Thanks for clarifying the 1929 story. BTW, when people ask what an ideal monetary policy would look like, I like to say something like 1927-29. I see a bit of shock in their eyes. We are so used to looking for “root causes” that people have trouble understanding why I think 1927-29 was near ideal. They think in terms of “Granger causality”, if X came before Y, it mush have caused Y. I want inflation to be especially low in booms (as does Hayek.) And 1927-29 had deflatio in a boom.

    Greg#2, I agree with this view of the Depression, and by the way I see my current blog as trying to stop the Fed from repeating the mistake of adopting a monetary policy so tight that NGDP actually falls.

    Jon, That’s that Mises quotation supports my interpretation.

    Devin, Good distinction between stopping an overheated economy, and overshooting into severe deflation.

    Peter, I don’t like the “effective demand” approach. It entirely depends on monetary policy. Suppose money was so tight that GDP fell 90%, would you argue that “the problem is there is way too much overcapacity,” or “it looks like we need expand the money supply to boost AD? There was no shoe bubble–do know people who were hoarding shoes that they didn’t really want? (scratch that, I forgot about wives.)

    Thruth, That’s a big if, as the Fed is actually not constrained by the zero bound. They can print enough money to buy up all of planet Earth. Some people say that’s really fiscal policy, but I don’t care. Buying financial assets with the thought of selling them when the deflation threat goes away is much better than bridges to nowhere.

  52. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 05:45

    the “ex ante” / “ex post” idea and language comes from Sweden in the early 1930s, an Hayek discussed the topic in a 1933 paper he delivered in Stockholm.

    Hayek shared a Nobel Prize with the guy who introduced it.

    Scott writes:

    “I thought the distinction between ex ante and ex post saving was a Keynesian idea. Do the Austrians also use it?”

  53. Gravatar of Jon Jon
    30. April 2009 at 06:05

    “Jon, That’s that Mises quotation supports my interpretation.”

    Yes precisely. The funny thing about this subject is that surely part of the question is not just “what is” but rather what were Mises, Hayek, etc thinking. Its hard to know for sure off the bat because their writings are legion and span 50 years wherein their opinions drifted.

    Vis-a-vis: “nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible.”

    I’m trying to reread the rest of Chapter 19 for a better citation on precisely what this means.

  54. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 06:58

    The question Scott, is how you answer the questions about the relations between productivity growth and money articulated by George Selgin and Friedrich Hayek — and then the on the ground specifics of productivity growth in the 1920s, the true rate of monetary growth, and the role of money in shaping the time / production goods of the economy. I’m guessing it is especially this last point that you still haven’t every imagines or conceived as an unavoidable facts about a production goods using economy.

    You understand the Cantillon Effect, right? Money growth enters the economy somewhere, creating production / consumption distortions — money growth changes or declines, then this structure is out of whack.

    Now think about that fact that longer production processes will only be started if they promise greater output — and that lower money / credit costs will lower the costs of starting these higher output processes.

    Add also that fact that longer production processes will bring production gooods into the structure of production that would _not_ be used without those new processes, e.g. marginal land, exotic metals, exotic forms of labor, etc. (see Hayek’s _The Pure Theory of Capital_)

    Imagine the Cantillon Effect putting these production processes in motion — then the supply and costs of money and credit suddenly going up.

    What happens next?

    Really think about this.

    Try it.

    You’ll mind will enjoy making new never before experienced connections between older mostly isolated patterns in your brain.

  55. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 07:00

    Sorry, I boggled this:

    “Imagine the Cantillon Effect putting these production processes in motion — then the supply and costs of money and credit suddenly going up.”

    Of course what I meant is:

    “Imagine the Cantillon Effect putting these production processes in motion — then the costs of money and credit suddenly going up, and the supply of money and credit suddenly going down.

  56. Gravatar of Bill Woolsey Bill Woolsey
    30. April 2009 at 07:15

    Ranson,

    Think about the public finance implications of money creation. What do people have to do to maintain their real money balances when there is deflation, zero inflation, or positive inflation? What does that imply about the relationship between their real income and other real expenditures? What happens to the resources freed up because
    people must act to maintain their real money balances? Why canot those reources be used to support more round about methods of production?

    What could go wrong? Lots of things. But there is an equilibrium impact of money creation on the allocation of resources that can be sustained and as well as we understand anything about macroeconomics, it should be that higher inflation rates generate a larger equilibrium impact on the allocation of resources.

    I think that the ability to spend money into existence, and that this process can create an increase in the base of the inflation tax does make a differnence. But it is unclear that this sort of disequilibrium (which matches actual excess money balances that people are itching to spend) lasts for long period of time. I think you are confusing the equilibrium impact of monetary regimes with the disequilibrium impact of mistakes, including the execptionally large mistkaes that seem likely as people learn about a new regime.

  57. Gravatar of fundamentalist fundamentalist
    30. April 2009 at 07:41

    Devin: “The classic Austrian mistake is to not realize the difference between scenario 2) and scenario 3).”

    Hayek once said that the worst mistake economists can make is to ignore monetary theory. The second worst mistake is to take it too literally. Mainstream econ does both. Keynesians ignore it and monetarists take it too literally. Many Austrians don’t want to see the Fed counter deflation during a depression because they know the Fed won’t be able to stop with countering deflation, but will continue to inflate long after the threat of deflation has ceased, not because they love the destruction caused by massive deflation. Hayek seems to have argued for an attempt to counter secondary deflation, but he was also humble about what the Feds could achieve. The process is not mechanical. A 50% decrease in interest rates will not create 50% more money. Nor will a 100% increase base money translate into a 100% increase in credit. This is not physics. The Fed has increased bank reserves by an enormous amount recently with little change in M1 or M2. Fed instruments have a great effect at the beginning and middle of booms, but almost no effect in depressions. So while you can agree that the Fed should attempt to alleviate secondary deflation, most of the time it simply is powerless because no one will borrow money.

  58. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 07:46

    Bill — “resources” are not “stuff” than can by used for any purpose and costlessly so. This is Econ 101 unknown it seems to the current generation of economists.

    “Think about the public finance implications of money creation. What do people have to do to maintain their real money balances when there is deflation, zero inflation, or positive inflation? What does that imply about the relationship between their real income and other real expenditures? What happens to the resources freed up because people must act to maintain their real money balances? Why cannot those resources be used to support more round about methods of production?”

    Bill — you’ll have to explain the microeconomics of the below statement to me, most especially the coordination problems involved:

    “What happens to the resources freed up because people must act to maintain their real money balances? Why cannot those resources be used to support more round about methods of production?”

    Also — how are you using the word “deflation” — would productivity growth produce “deflation” as you are using your words?

  59. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 07:57

    Bill, it the price of money and credit go up, longer time taking production processes profitable only at cheap money and credit rates will not be profitable, and will not be undertaken.

    This is the insight that Keynesian & British & American economists never understood — and certainly were prevented from even thinking by the mathematical of their models.

    Bill writes:

    “What happens to the resources freed up because people must act to maintain their real money balances? Why cannot those resources be used to support more round about methods of production?”

  60. Gravatar of fundamentalist fundamentalist
    30. April 2009 at 07:58

    Ssumner: “Like many others here you are giving me a real explanation for a nominal variable. Of course they can prevent NGDP from falling, look at Zimbabwe.”

    The Ricardo Effect works on nominal values, not real values. In fact, the distinction isn’t important to the Ricardo Effect. What’s important is relative prices, eg, the price of labor relative to sales revenue, or the cost of inputs relative to sales (ie, profits), or the price of capital goods relative to consumer goods, all in nominal values because businesses don’t calculate using CPI deflated numbers. This is a strange way to look at economics for those training in mainstream econ. I know, I earned an MA in mainstream econ and it took me a year to get my head around Austrian methodology. If you try to interpret Austrian econ in mainstream terms, it won’t make any sense.

    The Fed’s power to increase NGDP changes with the different stages of the business cycle. The Fed is virtually impotent in the beginning and middle of a depression. As the recovery begins the Fed’s power returns and grows as the boom sets in. The Fed’s power is at its peak when hyperinflation begins.

    Monetarists suffer from confounded effects in their statistics. They assume that all of a recovery from depression comes from monetary pumping. They completely ignore the Ricardo Effect, increased savings, and other things that happen in the economy to naturally start the recovery without monetary pumping. Statistical techniques cannot separate confounded effects.

    “I thought the distinction between ex ante and ex post saving was a Keynesian idea. Do the Austrians also use it?”

    Yes, Austrians use the concept, just not those exact terms. For most Austrians, ex-ante refers to plans or expectations and ex-post refers to reality or how well those plans worked out. I think Hayek actually used the terms in some papers. But one of the central characteristics of Austrian econ is the coordination of plans. When lending and savings equate ex-ante as well as ex-post, then plans are more likely to coordinate. When lending gets ahead of savings, as when the Feds pump money, plans by entrepreneurs require more resources than are available and the failure of coordination is guaranteed.

  61. Gravatar of fundamentalist fundamentalist
    30. April 2009 at 08:29

    Bill, Your post makes me think you don’t have a good grasp of Austrian econ. Austrians don’t oppose inflation because they see it as a tax and they oppose all taxes. Hayek and Mises did not oppose taxes for the central functions of the state. Rothbard took Austrian econ in the direction of opposition to all taxes, but few Austrians followed him.

    Austrians oppose inflation for the damage it does to society. Even mild levels of inflation transfer wealth from the late receivers of new money (usually wage earners) to the early receivers (usually those in government and financial services). It hurts business by taxing inflated profits, which leaves fewer funds for investment. It destroys the ability of depreciation to fund replacement equipment. And it only works to spur growth when it is unexpected, which always tempts central banks to resort to hyperinflation.

    In addition, inflation doesn’t happen to all goods at the same time as monetarists believe. It starts with capital goods, leading to high profits and overinvestment. It then proceeds to consumer goods, which kicks off the Ricardo Effect and the bust of the boom. The misallocation of resources of Austrian econ refers to the first stage when high profits lead to overinvestment in capital goods relative to the desire of consumers to fund those investments and wait for the increased production.

    Again, I think the confusion comes from trying to interpret Austrian econ in mainstream terms. Mainstream econ is about absolutes, nominal verses real. Austrian econ is the economic version of the theory of relativity. Relative prices, not real or nominal, are important.

  62. Gravatar of moldbug moldbug
    30. April 2009 at 08:38

    Scott,

    Moldbug, I don’t see how financial problems that destroy wealth and lead to less consumption would cause NGDP to fall. Zimbabwe has had lots of problems, and I’m sure consumers are tightening their belts (because of famine, literally tightening their belts), but their NGDP soared. So I don’t buy your explanation.

    Acme of Zimbabwe’s sales, measured in Zimbabwe dollars, rose – because Zimbabwe consumers had a lot more Zimbabwe dollars to exchange for Acme of Zimbabwe’s goods. Acme of America’s sales, measured in US dollars, fell – because American consumers had fewer USD to exchange for Acme of America’s goods. What’s hard to understand about this?

    Also, be very wary of Fisherine terms like “wealth,” “value,” and (worst of all) “real”, which purport to convert quantities of money into unitless numbers. You cannot just sweep the denominator under the rug this way. I didn’t say the financial crisis destroyed “wealth” – I said it destroyed USD and USD substitutes. Similarly, Gideon Gono was not producing “wealth” – he was producing ZD. (Ah, for the old Rhodesian dollar! Stable as a rock.)

    You say a fiat money system might work if well run, hmmm, that sounds a lot like a gold standard. Remember the gold standard of 1929-33?

    Not even the pre-1914 classical gold standard was true hard money: it had issued more claims to present gold than it could pay. Ie, its “gold cover” was not 100%. It was heavily watered with paper, ie, promises of future gold. This was standard operating procedure at the Bank of England and always had been.

    The post-WWI “gold-exchange” standard was a monster. Look up its gold cover. The transition from gold to fiat was a gradual one.

    The gold standard’s final collapse in 1929-33 was the collapse of a system which had been abused beyond its limits. If you step in front of a bus and it hits you, do you blame the bus?

    The right policy approach would have been a hyper-devaluation of the official currencies that were pegged to gold at an impossible level, eg say to $200 an ounce, restoring a reasonable gold cover. But there was no constituency for this policy, so it had no chance of happening.

    I don’t understand all your talk about interest rates. First of all, are you assuming the Fed determines interest rates? If so, you lose me right there. When the Fed tightened policy in December 2007 interest rates fell.

    By issuing currency and exchanging it for debt, the Fed has the power to set interest rates in any market in which it intervenes. In classical open-market operations, it only buys short-term Treasuries. This is changing, and will probably change more. In the end I think we’ll see it buying toxic waste.

    But it is useless to talk about “interest rates” in general. Which rate, exactly, fell? There is not one interest rate, but a yield curve. Moreover, at present the interest rate on private debt and government-guaranteed debt has separated. These are now separate markets. Rates in the former are quite high, rates in the latter are quite low.

    Professor Sumner, the problem here is simple: from the Misesian perspective, you are not studying economics. You actually don’t seem to know anything about economics. You know a lot about something you call “economics,” but it is not economics. It is to economics as a cuckoo is to a robin – a parasite that stole the name of economics, and ate its body.

    Your cuckoo is a system of quantitative models that early 20th-century central planners invented to obviate the study of economics. The plans didn’t work and the models do not seem to have any predictive power. From the robin’s perspective, this is not exactly surprising, n’est ce pas?

    If you genuinely want to evaluate Austrian economics, here is my recommendation. Treat it as an entirely different field, one which you know nothing about. And do the work necessary to learn it. Once you’ve learned it, you can compare it to your Chicago model-nomics and see which you prefer. This casual drive-by approach is not going to work.

    The easiest way to do this is to work through Rothbard’s Man, Economy and State – from front to back, all 800 pages of it. Don’t mine it for insights into how to fix your Chicago models. Read it as if you knew nothing at all. Zen mind, beginner’s mind. You will inevitably find points you disagree with – I sure do.

    Then, when you actually know the field, when you have a BMW, you can start trying to reconcile it with what you learned at Chicago. This is a useful exercise. Asking a bunch of BMW owners to unscrew random parts and mail them to you, so you can try to fit them on your Harley, is not.

  63. Gravatar of fundamentalist fundamentalist
    30. April 2009 at 08:53

    Bill, After a little more thought, I decided that it’s impossible for the economy to reach equilibrium with mild inflation, even as low as 2%. Here’s why I say that. The Fed has targeted low inflation in the past, and it seems to work for a while. An Austrian explanation would be that prices don’t rise significantly because there are a lot of unused resources from the depression. But almost always the Fed raises interest rates at some point during the expansion to thwart price inflation from increasing. Austrians might say that shortages of resources have begun to appear. So the Fed’s own efforts demonstrate that the economy cannot reach equilibrium with low levels of inflation.

    In addition, if equilibrium were possible at low levels of inflation, then a monetary theory of business cycles is simply wrong. We are left with nothing but the random “shocks” of mainstream econ as expanations. The monetary theory shows that price inflation is not important to business cycles caused by misallocation of resources. Misallocation can happen without price inflation as measured by an index. The misallocation of resources occurs because of monetary pumping, not price inflation. The 1920′s are the prime example, but the 1990′s come very close with its low level of price inflation. Misallocation happens because of relative prices, not absolute price inflation. Prices could be falling as measured by an index, while the relative prices of capital goods to consumer goods change and set in motion the Ricardo Effect and the business cycle.

  64. Gravatar of moldbug moldbug
    30. April 2009 at 08:56

    Devin,

    An interesting argument. I am certainly supportive of your case for “more band-aids.” As someone who has been involved in many total rewrites, what kills you is not the total rewrite – but the partial rewrite that pretends to be a total one. Let’s not try to fix the system until we’re really ready to.

    But I would argue that, if there is any magic pill behind the Industrial Revolution, it was not fractional-reserve banking but the joint-stock company. And more generally, the libertarian attitude toward business and contracts that was an accidental consequence of various conflicts in the British political system. (Leftists turn into “classical liberals” when their enemies are in charge of the state and running it on mercantilist lines.)

    MT is equivalent to a program of government loans, and monetary dilution can be equated to a tax, although it is a very nasty tax. Is it possible that the State can create useful enterprises by taxing and using the proceeds to drive down long-term interest rates? Sure. I wouldn’t rule it out at all.

    But, as Mises points out, it is very hard to make a case that this process has in fact sustainably lowered long-term rates. Dilution is a zero-sum game, after all. And remember that under the Bank of Amsterdam system, multiyear trading voyages around the world in wooden sailing ships were financed in hard money. I don’t believe the rates were that high, either.

    There is a lot of natural demand for future money. People retire, for example. They have a very sensible desire to buy 2049 money in 2009. They also have a desire to make sure that 2049 money is actually going to be there in 2049, something the State isn’t quite so good at.

    But your overall point stands: the total rewrite is a lot harder than anyone, even the modern Austrians, think it is. Transitioning to a hard-money system is not a matter of turning a few screws and adjusting a knob or two. You’ve really got to sell the Harley and buy a BMW, and that’s a level of “change” which is orders of magnitude higher than anything today’s USG can achieve.

  65. Gravatar of Bill Woolsey Bill Woolsey
    30. April 2009 at 11:17

    Fundamentalist:

    I have a good grasp of the Austrian Trade Cycle Theory. The problem with the theory is that it ignores the equilibrium impact of monetary regimes on the allocation of resources and confuses them with various disquilbrium impacts. Personally, I oppose using inflation as a tax, though I don’t oppose all taxes, seeing some as a necessary evil. I suspect Hayek and Mises would agree. My guess is that they didn’t focus on these equilibrium processes and confused them with the disequilibrium ones.

    I find your argument as to why a mild inflation cannot be an equilibrium preposterous. That is impossible because otherwise there could be no monetary theory of the business cycle? That is no argument. If no monetary theory of the business cycle is possible, then that is just too bad.

  66. Gravatar of Bill Woolsey Bill Woolsey
    30. April 2009 at 12:43

    Ransom:

    I am not a Hayek scholar. I am pretty sure I have read everything he wrote, though it was many years ago. I
    think I have a pretty good grasp of his trade cycle theory.
    (But I admit that entrepreneurs causing a cycle was new to me and I still don’t get that.)

    However, I think I have a veryt good grasp of microeconomics, particulary about how markets allocate resources, and particularly when there is a change in response to a new pattern of demands between different consumer goods. Changes in technology, shifts in the patterns of international trade, and changes in the allocation of resources between current and future consumption due to saving and investment.

    If I have any criticism of your approach, it is that it seems to me that you focus too much on the trade cycle theory. Specific capital goods are part of the market process all the time.

    Anyway, I think the productivity “norm” arguments about malinvestment are dead wrong. Increase productivity is only consistent with a higher purchasing power of money if the real demand for money is positively related to real income. If it wasn’t, then deflation would raise the real supply of money and given the real demand for money, there would be a surplus of money and reflation. If increased real income results in an increased real demand for money, and this is met by increased nominal money holdings obtained by smaller spending on real consumption than real income, then this is obviously a form of saving. It is also possible, of course, that real money balances could be obtained by a reduction in some other form of saving–accumulating less of some other asset. Regardless, if new money creation is used to fund loans, then this is no different than any other saving financing any other form of investment. Capital goods are specific. So what?

    Suppose a household purchases bonds out of current income. It saves. A firm sells bonds to the household to fund the purchase of some capital good. It invests. Resources are going to be reallocated away from the production of current consumption goods. Why? Because the household is buying less of them. They are being reallocated to produce capital goods. Why? Because the firm is buying more of them. Yes, resources aren’t just stuff and the capital goods are specific. So?

    Suppose the household chooses to save by holding more money. As income is earned in the form of money, it is not spent on anything, but by assumption, they aren’t purchasing the same consumer goods that they woudn’t have bought if instead of accumulating money they had bought bonds. The firm, rather than selling bonds, gets a loan from a bank that lends newly created money. The household is accumulating more money, the bank is creating more money. The household is purchasing less consumer goods. The firm is buying more capital goods. It is the same thing as before. (This is an increase in the quantity of money that
    would offset a decrease in velocity.)

    Now, suppose that the reason the household chooses to accumulate more money is that it has a higher real income. The household increases its real money balance by not spending the extra real income on more consumer goods, it rather accumulates money. The bank creates new money and lends it to the firm. Rather than producing more consumer goods, more capital goods are produced.

    How is this different if the household used part of an increase in income to buy bonds. It doesn’t increase consumption as much as it could have. The firm selling the bonds buys capital goods. Same thing.

    The way I see it, the productivity norm argument assumes that improved productivity lowers the price level. And then, because the price level is too low, the money supply is increased to get it back up. That increase in the money supply at the new lower price level creates monetary disquilibrium and malinvestment.

    But that isn’t what happens with a monetary regime based upon increasing the the nominal quantity of money to meet the growing demand for real money balances due to growing real income due to growing real output due to improving productivity. Households must accumulate real balances by purchasing fewer consumer goods now than they could, which frees up resources to produce capital goods. The demands for some goods rise more than others, some may fall. The supplies of some goods rise more than others. Relative price change. But the supply and demand for the typical good both rise. Quantities rise, some more than others. Relative prices change, of course, but some fall and some rise.. obviously.

    When the supply of a particular good rises because of improved productivity, other things being equal, total real output and total real income have both risen. But this is a small amount, and feeding this back into the demand for this good–is it a necessity, inferior, or a luxury, how much of the share of this small increase in total income impacts this particular market and how? It isn’t worth fooling with. I don’t.

    However, when we think about simultaneous increases in productivity for many markets at once, we can no longer imagine that all the markets just have shifts in supply and the demands are unchanged. Real income rises and so the demands for every good changes. Some more than others, and for inferior goods it shrinks. Abstracting from money, growing productivity in the economy raises both supply and demand, the quantities shift to the right (different amounts) and some prices rise and others fall. There is no real deflation. Relative prices can’t all fall relative to one another. Hopefully, they fall relative to real wages and necessarily relative to some real income or other. That is what increased productivity is.

    What this implies about money prices cannot be answered independent of monetary institutions. If we imagine that the nominal quantity of money is fixed, the only way that this could possibly result in lower money prices is if the real demand for money rises with real income. Otherwise, lower money prices would raise real money balances and result in an inflation of prices.

    Now, if real money demand does rise with real income, and the rising real incomes results in rising real demands to match the rising supplies and the price level in money terms stays the same, then the high real income results in a shortage of money. This would result in monetary disequlibirum. And, of course, prices fall until the real money supply rises to meet the real money demand.

    But that isn’t how such a monetary regime would operate. Real income and nominal income rise, demands and supplies rise. The price level is uchanged. Then there is a shortage of money and then the price level falls. Of course not. In reality, the price level would drop as the supplies of various goods rises, because people will know that the typical money demand will not rise. Real balances increase. This accomodates the increase in the real demand for money that is generated by the increase in real income.

    But, a stable price regime with growing nominal income isn’t going to work such that first the price level falls, then the money supply rises to bring it back up. No, people will expect that a growing economy will have growing money demands. Firms that expand productivity will expect to sell more at stable prices. Some money prices rise, others fall. It depends on the changes in the demand the different goods in the face of growing real income and the changes in the various supplies depending on how much productivity increases. And, of course relative prices change like usual. But rather than deflation increasing peoples real money balances so that it meets their growing demand, they have to save–spend less on consumer goods than they otherwise would, or perhaps, change the form of saving purchasing fewer other assets. And that frees up resources to produce capital goods.

    The allocation of resources is different in the different monetary regimes. But there is nothing unsustainable about either one. As long as productivity continues to grow, there is growing money demand, and the money supply grows with it.

    As I explained with my “taxation” post, even if we have price inflation (which I consider undesirable,) there is a need to maintain real money balances. Fewer consumer goods are purchased, or perhaps saving in some other form is reduced. But people are spending less than they could on something. And that frees up resources to produce whatever it is that new money is being used to purchase. There is a shift in the allocation of resources. That capital goods are specific is no more relevant than if we are analyzing what happens when the US quits producing cars in the U.S. and instead produces cattle to exchange for Japanese cars. Or, we produce fewer toys and underware and instead use U.S. resources to provide health care or impose the American way in the Middleast funded by borrowing from the Chinese. Sure, capital goods are specific. So what? The market reallocates resources all the time.

    That money can be spent into existence is important. That incomes are paid in the form of money and people can demand for money by refraining from spending out of current income is important. I am the last person to deny the possiblity of monetary disequilibrium. But there are important “equilibrium” processes going on too. As I said before, I think that Austrian Trade Cycle theory balls them up.

  67. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 14:42

    Bill — I’m having trouble getting inside your head. Sometimes is seems like you are reifying a macroeconomics construct, i.e. the “price level”.

    I’ll have to re-read your post again.

  68. Gravatar of ssumner ssumner
    30. April 2009 at 17:10

    Greg, I don’t think it makes much difference where money enters the economy. In fact I will go even further and say that I don’t even think it matters whether an expansionary monetary policy involves any actual new money at all. The Fed can reduce the demand for money by cutting reserve requirements. Even better you can have an expansionary monetary policy by simply committing to raise the money supply in the future. Suppose you commit to raise the money supply 20% in 5 years. That policy will impact AD right now, and not because any new money entered the economy right now. And as far as where it enters, it doesn’t matter whether the money is injected into New York of California, the effect on interest rates is the same. It doesn’t matter whether the new money is used to buy U.S. bonds of British bonds, the effect on interest rates is almost the same.

    I think in one of your comments you mentioned the price of money and credit. You do know they are different I assume. The price of money is the nominal rate ,and the price of credit is the real rate. Last fall the Fed was reducing the price of money and raising the price of credit. Does the Austrian model cover that scenario?

    Fundamentalist, So monetary policy is ineffective in a depression because “no one will borrow money?” That sort of Keynesianism was discredited 50 years ago. Zimbabwe is in a depression and believe me NGDP has been rising fast. There seem to be so many problems with Austrian monetary theory that I hardly now where to start:

    1. Austrians tell me that the Fed lowers interest rates and that causes all kinds of mischief. But how do they lower interest rates? In the 1930s rates were low and we had really tight money. In the 1970s rates were high and we had really easy money. So am I to assume that Austrians believe the Fed has a really tight money policy, this lowers interest rates, and this causes an investment boom? The problem with this is that in the 1930s investment went down not up. Correct me if I am wrong, but aren’t Austrians making the same mistake as Keynesians, equating low interest rates with easy money?

    2. Then you tell me that what really matters is not nominal variables, it is relative prices. OK, fine, but then why not have NGDP rise 5% a year forever? Then Austrians seem to tell me (unless I misunderstand), that steady inflation, even if anticipated would cause all sorts of mischief, malinvestment, etc. But why? Isn’t anticipated money neutral? I thought Austrians said relative prices mattered, not nominal variables? Then they tell me that even expected inflation can affect relative prices, but they have no model (that hasn’t been totally discredited) to explain how a fully anticipated monetary expansion aimed at steady inflation would cause relative price changes. Who gets the money first? That question doesn’t make sense, if inflation is expected it will be factored into wage contracts (as it was in the 1970s when inflation was expected.) So if someone can’t give me a model of why monetary policy matters that is not based on some outdated view of the “liquidity effect” on interest rates, or some sort of who gets money first, or some sort of non-rational expectations, then why should I take Austrian seriously? I already have a model that can explain business cycles. Here is my model:

    1. Monetary policy creates nominal shocks (unexpected changes in NGDP.)

    2. Nominal shocks have real effects (due to wage stickiness.)

    3. Real shocks can also create cycles, but most cycles are due to nominal shocks.

    Name one event in the last 100 years that Austrian economics can explain better than this model.

    Sorry to sound so harsh but if Austrians want to be taken seriously by right wing economists, they can’t keep using discredited Keynesian interest rate theory. And if money isn’t neutral, they have to come up with a better explanation than “late receivers of new money.” And they better stop talking about liquidity traps where monetary policy is ineffectual. (Or perhaps I should say they better get their story straight, as Austrian Bob Murphy was the one who gave me the Zimbabwe example–he finds the concept of liquidity traps just as absurd as I do.)

    Moldbug, One problem is that there are so many versions of Austrian here I don’t know which to study. Do I study the one that says the Fed can make inflation last forever, or the one that says they cannot. You say I don’t know anything about real world economics, just a bunch of abstract models. I had the exact opposite impression. I had the impression that it was the Austrians who didn’t know that when the Fed tightened policy in December 2007, rates fell all across the yield spread. From 3 months to 30 years. I still haven’t heard a good explanation from Austrians, but I have a good explanation–which involves rational expectations and the EMH. Please tell me the Austrian explanation. How can someone do good economics in 2009 still assuming people are ignorant? But that is what you have to assume if you are going to argue that the Fed can control both short and long term interest rates. How do they do that? Suppose monetary expansion leads to expectations of higher inflation? How then are they supposed to reduce long term rates? I don’t see any answers to these questions. And they are not academic questions. One of the causes of the 1970s inflation was the Keynesian idea that you could lower interest rates by adding money to the system. When interest rates started rising they grabbed a bucket to throw onto the fire, but found out is was gasoline, not water.

    A general comment to all responders, many of you seem to assume I am some sort of zombie, or clone of “mainstream economics.” You might want to ask yourself how I am almost the only mainstream economist who thinks tight money by the Fed caused the crash of late 2008. Why the monetary explanations that I have for events like the stock market crash of 1929 are also held by virtually no other mainstream economist. Why I totally reject the IS-LM model as being useless. I think it is unlikely that I would have staked out so many off-beat opinions (right or wrong) if I was the unthinking zombie being portrayed in many of the comments.

  69. Gravatar of Greg Ransom Greg Ransom
    30. April 2009 at 17:35

    Scott — Austrian economics is really is just real micro applied to money, credit and production goods, and conceived across time.

    Austrian economics doesn’t rule out anything allowed by the real world because the real world is by and large governed by microeconomic relations.

    Lawrence White and George Selgin I’d point to as leading modern Austrians doing the economics of money and banking.

    I’d recommend reading an article or two or a book or two by these very good economists.

    Ludwig Mises, of course, was one of the pioneers extending microeconomic thinking into the domain of money and banking.

    Scott wrote:

    “I think in one of your comments you mentioned the price of money and credit. You do know they are different I assume. The price of money is the nominal rate ,and the price of credit is the real rate. Last fall the Fed was reducing the price of money and raising the price of credit. Does the Austrian model cover that scenario??”

    To directly answer this, yes, I do know they are different.

    And I’d suggest asking a really good Austrian money and banking guy like White or Selgin to get a really good answer to how they cover the scenario you mention.

    I’d be going over my head to speak on the ins and outs of this, especially when I’d be pretending to speak for much more qualified money and banking folks.

    I’m not saying I wouldn’t have a good answer, I’m just afraid it wouldn’t be up to snuff in a technical sounding sense.

  70. Gravatar of TGGP TGGP
    30. April 2009 at 18:26

    All you zombies are simply clever enough to anticipate the reaction of the un-undead to a horde of homogenous hellspawn, and so have created a clever charade of internal disagreement. What your ultimate plan is I have no idea, but an ill wind blows no good.

    There have been many quite different Austrian economists. Mises is among the most prominent, but that doesn’t make him a final authority or sine qu non. Nor would I trust Rothbard (on a variety of subjects, actually). In Matthew Mueller’s typology Rothbard is the founder of a strand of Austrianism that subordinates it to libertarianism, distinct from the Misesian fundamentalist and organic Austrian schools of thought. According to Steve Horwitz, Austrian economics was not associated with opposition to fractional reserve before Rothbard. Mises did shift closer to that position from his earlier view in Theory of Money and Credit though.

    Hayek does seem less distinctly Austrian than Mises and because he said a lot of things over the years it is harder to pin down a view that would seem definitive.

    I’d like to hear Scott’s reasons for why wage rigidity exists. A lot of libertarians argue it’s due to government/union interference. Others have argued it’s a psychological artifact, an attempt to prevent morale from falling while discarding the least productive workers. You yourself have noted that wage cuts in the 1920-1921 recession enabled a speedy recovery. Why don’t we see that in every recession?

  71. Gravatar of Jon Jon
    30. April 2009 at 18:44

    Scott vis-a-vis your replies to “fundamentalist”. I don’t think he gives a fair summary of Austrian thought as it appears in Mises’s writings.

    In particular Mises often argues from the assumption of a stable-price level–one where the supply of money is elastic but set to match ‘demand’. e.g., such as when banks are operating under the real-bills doctrine (although not necessarily so).

    The Austrian critique is then focused on what happens if the bank attaches a rate-of-interest to loans (issued in notes) that is below the social ‘time-preference’.

    Mises is not concerned that rates are low. He’s concerned about nominal rates that are below the natural nominal rate (given an inflation expectation) or the equivalent expression in real-terms.

    Then Austrians seem to tell me (unless I misunderstand), that steady inflation, even if anticipated would cause all sorts of mischief, malinvestment, etc. But why? Isn’t anticipated money neutral?

    Mises argues that because anticipated inflation is incorporated into all money rates, anticipated inflation is not useful–it does not alter the growth path of the economy or effect any sort of redistribution.

    Depreciation of money can benefit debtors only when it unforeseen… those who lend money will demand higher interest in order to compensate their probable loss of capital…
    It is a mistake to think that the depreciation of money [necessarily] stimulates production.

    He then argues that a program of inflationary shocks then would destroy the utility of money.

    His position against inflation per-se stems instead from his belief that inflation once embarked upon will spiral out-of-control. His views here are undoubtedly shaped by the german-hyperinflation. Indeed, where the first edition of the ‘Theory of Money and Credit’ is rather neutral on the subject of inflation (pointless but not necessarily harmful if expected); the 1924 edition included many new passages/sections/chapters and takes a very different tone.

    To wit he argues:

    In all countries where inflation has been rapid, it has been observed that the decrease in the value of money has occurred faster than the increase in its quantity… An expected fall in the value of money is anticipated by speculation so that the money has a lower value in the present than would correspond to the relationship between the immediate supply of it and demand for it. Prices are asked and given that are not related to the present amount of money is circulation nor to the present demands for money, but to future circumstances… But there is not enough money available to pay the prices that correspond to the presumable future supply of and and demand for it. And so it comes about that commerce suffers from a shortage of notes…

    Obviously he has in mind hyper-inflation. But in the 1924 edition, he is deeply skeptical that society could restrain itself from hyperinflation once it accedes to any inflation.

  72. Gravatar of Jon Jon
    30. April 2009 at 20:10

    Then Austrians seem to tell me (unless I misunderstand), that steady inflation, even if anticipated would cause all sorts of mischief, malinvestment, etc. But why? Isn’t anticipated money neutral?

    But there is a concern that the exact-rate cannot be anticipated. e.g., under your NGDP target only the sum of real-growth and inflation is constrained.

    Hayek writes:

    The whole conventional analysis reproduced in most textbooks proceeds as if a rise in average prices meant that all prices rise at the same time by more or less the same percentage, or that this at least was true of all prices determined currently on the market, leaving out only a few prices fixed by decree or long term contracts, such as public utility rates, rents and various conventional fees. But this is not true or even possible. The crucial point is that so long as the flow of money expenditure continues to grow and prices of commodities and services are driven up, the different prices must rise, not at the same time but in succession, and that in consequence, so long as this process continues, the prices which rise first must all the time move ahead of the others. This distortion of the whole price structure will disappear only sometime after the process of inflation has stopped. This is a fundamental point which the master of all of us, Ludwig von Mises, has never tired from emphasizing for the past sixty years…

    That the order in which a continued increase in the money stream raises the different prices is crucial for an understanding of the effects of inflation was clearly seen more than two hundred years ago by David Hume–and indeed before him by Richard Cantillon. It was in order deliberately to eliminate this effect that Hume assumed as a first approximation that one morning every citizen of a country woke up to find the stock of money in his possession miraculously doubled. Even this would not really lead to an immediate rise of all prices by the same percentage. But it is not what ever really happens. The influx of the additional money into the system always takes place at some particular point. There will always be some people who have more money to spend before the others…

    To such a change in relative prices, if it has persisted for some time and comes to be expected to continue, will of course correspond a similar change in the allocation of resources: relatively more will be produced of the goods and services whose prices are now comparatively higher and relatively less of those whose prices are comparatively lower. This redistribution of the productive resources will evidently persist so long, but only so long, as inflation continues at a given rate. We shall see that this inducement to activities, or a volume of some activities, which can be continued only if inflation is also continued, is one of the ways in which even a contemporary inflation places us in a quandary because its discontinuance will necessarily destroy some of the jobs it has created…

    But before I turn to those consequences of an economy adjusting itself to a continuous process of inflation, I must deal with an argument that, though I do not know that it has anywhere been clearly stated, seems to lie at the root of the view which represents inflation as relatively harmless. It seems to be that, if future prices are correctly foreseen, any set of prices expected in the future is compatible with an equilibrium position, because present prices will adjust themselves to expected future prices…

    More important, however, is the fact that if future prices were correctly foreseen, inflation would have none of the stimulating effects for which it is welcomed by so many people…

    Hayek continues, perhaps more contentiously:

    But, and this brings me to my next point, “full employment” in his sense requires not only continued inflation but inflation at a growing rate. Because, as we have seen, it will have its immediate beneficial effect only so long as it, or at least its magnitude, is not foreseen. But once it has continued for some time, its further continuance comes to be expected…

    To maintain the effect inflation had earlier when its full extent was not anticipated, it will have to be stronger than before. If at first an annual rate of price increase of five percent had been sufficient, once five percent comes to be expected something like seven percent or more will be necessary to have the same stimulating effect which a five percent rise had before. And since, if inflation has already lasted for some time, a great many activities will have become dependent on its continuance at a progressive rate, we will have a situation in which, in spite of rising prices, many firms will be making losses, and there may be substantial unemployment. Depression with rising prices is a typical consequence of a mere braking of the increase in the rate of inflation once the economy has become geared to a certain rate of inflation.

    All this means that, unless we are prepared to accept constantly increasing rates of inflation which in the end would have to exceed any assignable limit, inflation can always give only a temporary fillip to the economy, but must not only cease to have stimulating effect but will always leave us with a legacy of postponed adjustments and new maladjustments which make our problem more difficult. Please note that I am not saying that once we embark on inflation we are bound to be drawn into a galloping hyper-inflation. I do not believe that this is true. All I am contending is that if we wanted to perpetuate the peculiar prosperity-and-job-creating effects of inflation we would have progressively to step it up and must never stop increasing its rate. That this is so has been empirically confirmed by the Great German inflation of the early 1920s. So long as that increased at a geometrical rate there was indeed (except towards the end) practically no unemployment. But till then every time merely the increase of the rate of inflation slowed down, unemployment rapidly assumed major proportions.

  73. Gravatar of Bill Woolsey Bill Woolsey
    1. May 2009 at 02:42

    Scott:

    It doesn’t matter where the new money enters the economy? For what? The consequent level of nominal expenditure? Perhaps not. But what about the allocation of resources? For years now, you have accepted govermment seniorage as a political necessity. What good does it do the government if it has no impact on the allocation of resources?

    You say that you thought that changes in the money supply are neutral. Well, I will add my voice to others here. Austrian economists insist that it isn’t neutral, even if prices and wages are perfectly stable. (I agree with this claim, but I just don’t think it is of great practical significance.)

    As for the notion that there are different varieties of Austrian economics and you don’t know which one to study… well, are all Keynesians in agreement? Please keep in mind, that you are counting as “varieties” of Austrian thought the views of people who would be parallel to a random center-left noneconomist posting on a blog and desdribing his or her advocacy of creating jobs by goverment spending as Keynesian, and giving a hodgepodge of reasons wa to why this is necessary and just. (Substitute creating jobs by government spending with vastly increasing the role of gold in financial markets and you will understand a good bit of lay Austrian economics.)

    On the other hand, you have had some people posting in this thread who know what they are talking about.

    I am sure you can find some self-described Austrians who regularly forget the difference between real and nominal interest rates. I am sure you can find some good Austrian economists who fail to mention it, but generally, it is real interest rates that concern them. They all know the standard things about expected and unexpected inflation.

    Anyway, sometimes Austrian economists get really abstract and talk about how money injects impact relative prices somehow. Other times, they get a bit more specific and making the realistic assumption money enters through the banking system, and then it is market and natural interest rate stuff. If you think that Austrians are about nominal interest rate targetting, then you are not paying attention. One key focus would be how nominal interest rate targeting by central banks causes macroeconomic distrubrances.

    In you comments, you claim that announcing a future increase in the money supply will result in inflation today. I understand how that could happen. But surely, there are limits. Suppose the money supply is dropped to zero (or close to it) today, while there are promises it will be near infinite next year? We get an infinite price level today with a near zero nominal quanity of money? If any quantity of base money, no matter how small will accomodate any price level, no matter how high, then I don’t see how the price level is determined.

    I think that this is pointing to those new classical models where the demand for money is treated as an asset demand only. In other words, models with “money” where it isn’t really money.

  74. Gravatar of Bill Woolsey Bill Woolsey
    1. May 2009 at 03:30

    Ransom:

    I use macroeconomic concepts all the time.

    Not only the price level, but aggregate demand (both
    real and nominal,) potential income, income and output (aggregate,) saving, investmnet, “the” interest rate, the quantity of money, and on and on.

    I think all of these concepts reflect realities about the
    world.

    However, I at least think about all of these things in terms of individual action. Highly abstract arguments about the illegitimacy of some marcoeconomic concept are usualy lost on me. Similarly, highly abstract arguments about the market process–well, I generally agree, but I want more.

    About a month ago, I read the first essay in “The Fluttering Veil” the collection of Yeager’s work put together by Selgin. It was written a few months before I was born (in 1956,) I was surprised to see how much of my understanding of the current crises was there in that essay. I am more of a Wicksellian than Yeager, but I see Yeager’s approach to be central. (The Keynesian Diversion opened my eyes–many, many years ago.)

    Critics of Austrian trade cycle theory who know what they are talking about (often because they are defectors,) generally accept that disequilibrium distortion in realtive prices and the composition of output is possible, but of little quantitative significance in the real world. For me, anyway, what you call the secondary depression, or the secondary deflation _is_ the problem. My basic response to the Austrian business cycle theory is, “let the malinvestments work themselves out.” Let nominal and real interest rates adjust. Let the allocation of resources change. But I don’t worry about them in choosing a desirable growth path for nominal income. And once you choose, keep to the growth path.

    One version of the Austrian Trade Cycle theory argues that it is necessary to ever accelerate inflation to support the malinvestments. My response has always been, don’t. What a stupid policy that would be. I favor a stable purchasing power of money, but hypothectally speaking, if a 2% inflation rate target has involved some malinvestments, and they will be liquidated unless money creation is accelerated.. just say no. Stick to the target. Let the malinvestmnets work themselves out. So now what? I don’t claim that the allocation of resources and constellaction of relative prices would be the same as under some other target. But I think to claim that it is unsustainable is mistaken. And that is why in a previous comment I pointed out that some Austrian economists shift into moral arguments at that point. I think morality is important, of course. But let’s not confuse moral with sustainable.

    As I said in my “tax” post, I think that many Austrian economists, including the greats, have confused disquilibrium and equilibrium processes. Malinvestment is sometimes sustainable and only a malinvestent in some moral sense by comparison to the allocation of resources that would exist under an alternative policy regime. Othertimes, the malinvestment is an unsustainable disequilibrium phenemonen where trying to maintain them through maintaining permanent monetary disequilibrium surely must lead to disaster.

  75. Gravatar of Bill Woolsey Bill Woolsey
    1. May 2009 at 03:32

    Scott:

    Big Whoops…

    Money isn’t neutral even if prices and wages are perfectly flexible. (Stable.. the opposite…. Oh well.)

  76. Gravatar of Thruth Thruth
    1. May 2009 at 05:17

    This entire comment stream is the reason I’m reasonably sympathetic to “freshwater” economics aka structural modeling. The models are clear statements of underlying assumptions with logically deduced results and empirically testable implications. If you can’t make your arguments concrete then there’s a really good chance they are “bunk”

  77. Gravatar of Greg Ransom Greg Ransom
    1. May 2009 at 07:26

    Bill writes:

    ” I at least think about all of these [macro concepts] in terms of individual action. Highly abstract arguments about the illegitimacy of some marcoeconomic concept are usualy lost on me. ”

    You’ve got two sentences here in conflict — following through the “individual action” to get the macro concepts requires great intellectual gifts and produces highly abstract arguments.

    If you don’t have the intellectual gifts and you don’t go through the highly abstract arguments, you are only fooling yourself if you think your are grounding legitimate “macro” concepts in the micro. I think 99.97% of economists are fooling themselves — and I have extremely solid grounds from thinking so, i.e. use of a “representative agent”, the utter lack of a time structure of heterogeneous capital, the lack of individuals learning through time using their local subjective judgment (vs. “people” represented by a math function).

    The issue you raise about what counts as significant in terms of “size” is important, of course. I doubt we’d make much progress hashing it out in the comments section of a blog post.

  78. Gravatar of fundamentalist fundamentalist
    1. May 2009 at 07:39

    Ssumner: “So monetary policy is ineffective in a depression because “no one will borrow money?” That sort of Keynesianism was discredited 50 years ago.”

    Then why does it still happen? Greenspan referred to it as “pushing on a string” and borrowing hasn’t started again in this depression regardless of how low interest rates are. Keynes blamed the lack of demand for loans on the declining efficiency of capital. Austrians blame it on uncertainty.

    Ssumner: “Zimbabwe is in a depression and believe me NGDP has been rising fast.”

    That sort of thing is rare, but Mises handled that issue when he wrote about the hyperinflation in Germany during the 1920’s. Zimbabwe’s situation can only happen in hyperinflation. Again, the problem with monetarism is that it takes the quantity theory of money too literally. The quantity of money has different effects at different times depending on a variety of factors.

    Ssumner: “There seem to be so many problems with Austrian monetary theory that I hardly now where to start: 1. Austrians tell me that the Fed lowers interest rates and that causes all kinds of mischief.”

    Your problem understanding Austrian monetary theory is in thinking only in absolutes and aggregates. Austrian econ is a theory of relativity. Fed policy is loose if it sets interest rates at a lower rate than what would exist in the market place. Market rates are determined by supply/demand, price inflation, and risk. In turn, demand for loans is determined partly by interest rates and partly by uncertainty. In depressions, uncertainty overwhelms the effect of low interest rates.

    Ssumner: “Isn’t anticipated money neutral?”

    Only in the sense that it doesn’t cause the effect that inflationists desire, which is increased investment. As Mises and Hayek repeatedly point out, for monetary pumping to work it must increase at increasing rates. But money is never neutral.

    Ssumner: “Then they tell me that even expected inflation can affect relative prices, but they have no model (that hasn’t been totally discredited) to explain how a fully anticipated monetary expansion aimed at steady inflation would cause relative price changes. Who gets the money first?”

    With regard to the monetary theory of business cycles, capital goods producing businesses get the money first as they respond to lower interest rates and expand investment. Expanding businesses hire unemployed workers and buy materials. When idle workers and materials are used up, capital goods producers must compete with consumer good producers for scarce resources. This causes the prices of materials and labor to rise. At the same time, more workers are consuming greater quantities of consumer goods, causing those prices to rise. You’ll never understand Austrian econ unless you break up the aggregates that you learned from mainstream econ. You have to divide production into at least two parts, capital goods and consumer goods.

    Ssumner: “That question doesn’t make sense, if inflation is expected it will be factored into wage contracts…”

    Again, you’re focusing on aggregates. Austrian econ doesn’t see any aggregates. If you can’t get beyond the aggregates, you’ll never understand Austrian econ and you’ll dismiss it because you don’t understand it (as most mainstream economists have done), not because you disagree with it. One of the great insights into business cycles was that they happen primarily in the capital goods industries. And while financial advisors don’t know Austrian econ, every one of them will tell you that. And they’ll tell you that capital goods industries are much more volatile and consumer goods producers and retailers are defensive stocks if you’re worried about a depression. All economists in the 1930’s understood this except Keynes and mainstream econ follows Keynes on that.

    You’re exactly right that all wages will rise with anticipated inflation. So why do we have depressions following long periods of low price inflation? Because in the later stages of a boom capital goods makers are still borrowing and producing more than they would if interest rates were higher. They are producing more capital goods while consumers are demanding more consumer goods. This discoordination between what producers make and what consumers demand is the malinvestment that Austrians talk about endlessly. Coordinating the two requires that loans for investment be no greater than the amount of savings. In other words, ex-ante savings must match ex-post savings.
    All wages rise together with expected low levels of inflation. But their impact is different for different industries. This is where the Ricardo Effect kicks in. Demand for consumer goods increases as more people become employed, so nominal profits rise in the consumer goods industries. So while wages in consumer goods industries have risen at the same rate as in capital goods industries, they haven’t risen as fast as revenues. Wages become cheaper relative to sales in consumer goods industries, so businesses use more labor and less capital equipment. That much is standard micro econ 101.

    Less demand for labor-saving capital equipment by consumer goods producers causes demand for the output of capital goods producers to fall. So for capital goods producers, wages are rising because of expected inflation and sales revenue is falling and profits are falling. Falling profits lead to less investment. Eventually, some companies fail and lay off workers.

    So you can see that wages and prices are rising at expected levels because of low, steady price inflation. But the effects are different for different industries because of the Ricardo Effect. Besides, expected inflation has little to do with business cycles, because just as happened in the 1920’s and 1990’s, expected inflation can be very low while monetary pumping is high because productivity increases mask the effects of the monetary pumping. It’s the monetary pumping that causes malinvestments, not price inflation.

    Ssumner: “Name one event in the last 100 years that Austrian economics can explain better than this model.”

    The depression of 1991. Where was the monetary shock? In addition, your model doesn’t explain the very obvious and well-documented fact depressions happen in the capital goods industries first and foremost and affect consumer goods industries much later and to a lesser degree. Austrians don’t deny that monetary shocks have consequences; they’re just more obvious than the consequences of expected inflation.

    Bill: “My guess is that they didn’t focus on these equilibrium processes and confused them with the disequilibrium ones.”

    I think you see equilibrium effects where none exist because you can’t get beyond the aggregate data. Disequilibrium effects occur below the aggregate level. The monetary theory of business cycles is still the best we have, but you’ll never get it if all you can see is the gross aggregate figures that mainstream econ focuses on.

  79. Gravatar of Greg Ransom Greg Ransom
    1. May 2009 at 07:48

    Well, Austrians also tell a story about how lots off what once were profitable investments at the longer-term structure of the production process now aren’t worth borrowing to finance.

    Did you see the video of almost completed houses being smashed in Victorville, CA?

    “borrowing hasn’t started again in this depression regardless of how low interest rates are. Keynes blamed the lack of demand for loans on the declining efficiency of capital. Austrians blame it on uncertainty.”

  80. Gravatar of azmyth azmyth
    1. May 2009 at 09:39

    On the earlier line of discussion – I was definitely thinking of the more mainstream branches of Austrian economics. Many Austrians argue for the first best world, even if it bears no resemblance to what we have in place. This sort of argument is important, but we need to remember policy constraints of the U.S. government. Full reserve banking gold standards might be better, but if we can’t implement them, who cares? BMW mechanics need to know how to fix Harleys if there are no BMWs around.
    One of the major points of Austrian economics is micro foundations of macro behavior. While the malinvestment story can generate the initial crash, the government prevention of the correction is what lengthens the recession. Just look at the National Industrial Recovery Act or the Smoot-Hawley tariff. They don’t show up in many macro analyses, but they had macro effects, such as increased unemployment and stickier prices. In my opinion, prevention of misguided government policy is important enough to justify temporary inflation of the money supply, even though I think a zero long run inflation goal would be beneficial.

  81. Gravatar of fundamentalist fundamentalist
    1. May 2009 at 09:52

    Greg, you’re right, I should have included the wealth destruction that takes place. Good point!

    asmyth, good points, too. I tend to go along with Hayek who thought we would never get rid of fractional banking or return to gold. The next best solution is a wiser Fed. Personally, I liked Greenspan’s approach in his first term of targeting the price of gold. I thought that worked very well. Too bad he abandoned it. Meanwhile, the Fed’s shennanigans provide an opportunity for Austrians to make a lot of money. I don’t have any illusions about changing the minds of mainstream economists, but I’ll console myself by making big bucks from their silly policies. BTW, that’s essentially what Kyosagi (Rich Dad Poor Dad) says they super wealthy do.

  82. Gravatar of fundamentalist fundamentalist
    1. May 2009 at 10:03

    Bill: “One version of the Austrian Trade Cycle theory argues that it is necessary to ever accelerate inflation to support the malinvestments.”

    It’s not one version; it’s central to the Austrian cycle theory of everyone. But Austrians don’t recommend accelerating inflation. They’re saying that steady inflation won’t have the effect that inflationists such as mainstream economists want. You have to surprise people in order to get the desired effects. That requires increasingly accelerating inflation. No Austrian recommends it. They’re just explaining why steady inflation doesn’t produce the desired results.

    Bill: “Malinvestment is sometimes sustainable…”

    Not if you understand what Austrians mean by malinvestment. It is synonymous with unsustainable. Austrian malinvestment is the discoordination between consumer demand and supply. Capital goods producers are busy producing too many capital goods that will go to waste and not enough consumer goods. That is not sustainable for very long. The reasons it can last years is 1) idle resources left over from the depression and 2) capital consumption.

  83. Gravatar of moldbug moldbug
    1. May 2009 at 10:24

    Professor Sumner,

    One problem is that there are so many versions of Austrian here I don’t know which to study. Do I study the one that says the Fed can make inflation last forever, or the one that says they cannot.

    Study this one.

    You’ll note that it starts not with the Fed and inflation, but with Robinson Crusoe. It’s a few hundred pages before you get to anything macroeconomic. Of course, if you want your macro models to be grounded in micro logic, that’s pretty much what you’d expect, n’est ce pas? I really wasn’t kidding when I said that for a Chicago economist to learn Austrian economics, he has to start from scratch.

    I had the exact opposite impression. I had the impression that it was the Austrians who didn’t know that when the Fed tightened policy in December 2007, rates fell all across the yield spread. From 3 months to 30 years. I still haven’t heard a good explanation from Austrians, but I have a good explanation–which involves rational expectations and the EMH. Please tell me the Austrian explanation.

    Again, you’re asking us to fix your Harley. The modern loan market is a behemoth. It has seventeen different types of government intervention, half of which are concealed, and would instantly collapse without it. Why should anyone be able to understand it? Your best bet is probably to chase down an Austrian economist who is also a working financier, such as Sean Corrigan, and ask him.

    Why did yields decline? Why did Treasuries rally? Why did the price of turnips, gold, or Apple stock go up? Because demand for turnips increased and supply of turnips didn’t. This answer is 100% accurate and will be approved by all Austrian economists anywhere. Why did people suddenly want all these turnips?

    Well, I don’t know, but I can guess. My guess is that what was happening in December 2007 was an extreme bout of risk aversion. In a healthy loan market, there is one risk-free interest rate at every term. For private loans which are not risk-free, the market’s estimate of default probability can be computed from the risk-free interest rate and the price of the bond.

    This relationship no longer works. To generalize wildly, there are two loan markets: the market for safe loans, and the market for toxic assets. The only buyers for the latter are vulture funds.

    Thus, my guess is that what happened in December 2007 is that a large quantity of demand for future money exited securities like MBS, and moved into Treasuries, which of course are the risk-free securities which define your interest rate. Here is your demand for turnips. Hence, the Treasury rally to which you refer.

    This strikes me as a plausible explanation. Is it true? I have no freakin’ idea. Prices are data; we can only guess at the causes behind them. Maybe someone was just very hungry and wanted a lot of turnips.

    But that is what you have to assume if you are going to argue that the Fed can control both short and long term interest rates. How do they do that? Suppose monetary expansion leads to expectations of higher inflation? How then are they supposed to reduce long term rates?

    What on earth do “expectations of higher inflation [ie, CPI]” have to do with long-term rates? 2019 money is a good like any other – turnips, etc. Its price (in 2009 money) is set by our old friend, supply and demand. It is most certainly not set by your models.

    (In particular, I often hear people saying that lenders “demand high interest rates to compensate them for inflation.” This just doesn’t compute. Lenders always demand the highest interest rate the market will give them – they want as many 2019 dollars as possible for their 2009 dollars. If you want to causally motivate an increase in interest rates, ie a decline in bond prices, you have to show an increase in supply or a decrease in demand. It may be possible to relate one or the other to CPI expectations, but it sure ain’t a no-brainer.)

    Since the Fed can print an arbitrary quantity of 2009 dollars with which to buy 2019 dollars, they can add an infinite amount of demand to the market. They can thus drive prices as high as they like. They can even drive the price of 2019 dollars (in 2009) above the price of 2009 dollars, creating negative interest rates. They can, of course, do the same for turnips.

    Of course, this is only one side of the equation. Because 2009 dollars will all eventually exist in 2019, issuing more 2009 dollars may result in an increased supply of 2019 dollars, ie, of bonds maturing in 2019.

    But when you have infinity on one side of the equation, you don’t much care what’s on the other. (Note that I didn’t say the Fed could set rates to zero without causing hyperinflation.)

  84. Gravatar of ssumner ssumner
    1. May 2009 at 16:10

    There’s a lot here, so I’ll just take some for now:

    Greg, I have read some of Selgin and White, and agree they are good economists. (Although I don’t always agree.) I know a bit more about Selgin, and agree with him more than I disagree.

    TGGP, A good point about 1920-21, but I think it is also important to understand the “glass half empty” part. When I did a real wage study back in the 1980s I seem to recall that if you deflate by the WPI, 1921 saw both the largest (one year) increase in real wages and the largest (one year) decrease in industrial production in the entire 20th century. Nominal wages fell, but the WPI plummeted. (This is from memory, it might have been the second largest drop in IP.) I don’t think that’s a coincidence. Rather, I think the sticky-wage model nicely explains the 1921 depression. So far I may appear to be disagreeing with you, but I am not. The recovery was amazingly fast in 1922, and I think that supports the Austrian/libertarian view of the evils of labor market intervention, of the fact that Harding is underrated, etc. Indeed I wish Austrians would be more positive about the entire 1920s, as I believe the Great Depression was caused by mistakes after 1929. Although Greg pointed out that this is probably a mistaken impression on my part from seeing a few articles blaming the 1929 crash on easy money in preceding years. I gather the Austrians have plenty to say about Hoover and FDR–and much of it is probably correct.
    Sorry for the long digression, the bottom line is that wage stickiness is somewhat of a problem in any economy, but Hoover made it worse, and FDR made it still worse.

    Jon, I agree that some of the commenters are not speaking for Mises, but I also think the whole interest rate approach used by Mises is easy to abuse. Everyone assumes that rates were cut too low in 2002-03, but how do we know what the natural rate was back then? Many people thought that for various reasons the natural rate was quite low at that time. I do agree that monetary policy was too expansionary in 2004-07, but I also think if rates weren’t cut sharply in 2002 we might have ended up in deflation back then. That’s why I think expected NGDP growth is the only reliable indicator. NGDP was low in 2002, fast in 2004.

    I think you are exactly right about Mises and the memory of hyperinflation. You and I seem to approach many of these history of thought issues in a very similar way. I have argued that Keynes was also a lifelong opponent of fiat money partly because he identified it with hyperinflation. The more one studies history of thought, the more one realizes how powerfully events and institutional setups influenced how people thought about issues.

    David Glasner would love your comment on Hayek. David has strongly argued that it was Hayek, not Friedman, who was the real discoverer of the natural rate hypothesis. And it is clear in the quote you provide that Hayek understood this issue fully. So it’s quite possible that one could find an anti-inflation quotation from gold standard-era Hayek, and another quotation such as you provided (from the 1950s?) admitting that expected increases in money could be neutral. BTW, readers should note that although he sounds negative in his “no stimulative effect” comment regarded anticipated money, it is actually music to my ears. I favor a roughly 2% inflation rate precisely because I don’t believe it would be stimulative. If it was stimulative, it would have the distortionary effects that Austrian rightly worry about.

    Bill, My previous tirade should not be viewed as an attack on all Austrian economics, but was directed against a series of comments that seemed both wrong-headed and too confident that they were right and I was clueless. So other readers should not take it too seriously.
    I know the expected future money hypothetical sounds pretty farfetched, but in my George Warren post I argued that’s exactly what happened in 1933. During most of 1933 the money supply was pretty flat, but output and prices soared. Why? the devaluation raised the expected future money supply, and hence the current price level. Surprisingly, the boom didn’t occur because of the terms of trade effects, our trade balance actually worsened–it was strong domestic demand. It seems farfetched, because there are actually few real world cases of expected future money growth changing. Another example is the week in 1997 when the Blair governemtnannounced the Bank of England would be made independent. No immediate change in the money supply, but future expected money growth fell. And (British) TIPS spreads showed a sudden 50 basis point drop.

    NOTE:

    I was planning a post on my overall view of Austrian macro, but Bill may have saved me the trouble, as the paragraph starting with “Critics of” in his 3:30 post is exactly my view. The phrase “of little quantitative significance” exactly explains my view of late 2006 to mid-2008, an overbuilt housing sector gradually losing resources to other sectors, subtracting about a point each quarter from RGDP growth. Then after mid-2008, sharply falling NGDP growth, WHICH IS COMPLETELY THE RESPONSIBILITY OF MONETARY POLICY, caused the current crises, which has cost trillions in bailouts, stimulus, higher future taxes on labor and capital, the President running auto companies, etc. So the Austrians may be right about 2006-08, but most of the Austrian commenters seem to think that the “secondary depression” of 2008-09 is exactly the same problem, when I don’t think it is. It was avoidable even as late as mid-2008.

  85. Gravatar of TGGP TGGP
    1. May 2009 at 19:28

    Let’s grant the existence of wage rigidity, even in 1920-1921. You don’t seem to think that other prices are rigid. Why is it that wage rigidity exists? What are the microfoundations?

    You point to Hoover as a cause of greater-than-average wage rigidity. Do you think the present case is similar? Casey Mulligan has been arguing that part of our problem is a leftward shift in the supply of labor. I think he might be defining it in a non-standard way though.

  86. Gravatar of Jon Jon
    1. May 2009 at 19:38

    Everyone assumes that rates were cut too low in 2002-03, but how do we know what the natural rate was back then? Many people thought that for various reasons the natural rate was quite low at that time.

    Certainly we do not… But Mises would argue, I think, that precisely because of that uncertainty, interest rates should be allowed to float as they would given an active law-of-reflux return to their neutral position.

    Although its possible that the integration of post-communist labor did lower the natural rate, I do not find the evidence compelling. In particular, I’m not convinced that the timing for that explanation fits:

    http://www.nowandfutures.com/images/m2m3_cpi_money_supply.png

  87. Gravatar of StatsGuy StatsGuy
    1. May 2009 at 21:12

    Very nice post and discussion, sorry I found it so late.

    Might I just add this graph to the debate? It is, I think, the simplest and strongest piece of evidence I have encountered suggesting that the Austrian approach – get rid of all government-backed currency and go back to the pre-Bretton-Woods world – is bonkers.

    http://www.organissimo.org/forum/uploads/monthly_09_2007/post-353-1188669960.jpg

    If the Austrians are correct that govt currency management worsens the business cycle, then exactly how does one explain the noticeable reduction in volatility?

    Prior to WWII, this looks like an undamped oscillating system – as the industrial revolution progresses volatility accelerates. After WWII, not so much.

    I am certainly not the first to observe this datapoint, and I have yet to hear a decent Austrian response.

  88. Gravatar of Greg Ransom Greg Ransom
    1. May 2009 at 21:52

    It’s really important not to confuse theory and the empirics on the ground of any particular historical episode.

    Information is often bad and most usually very complex in any particular historical episode.

    If the empirics on the ground don’t instantiate the demands of some particular bit of machinary implied by microeconomics, this doesn’t “test” the microeconomic construct, it often simply says that the construct isn’t applicable in the case at hand. And sometimes one bit of microeconomic machinary is simply overwhelmed my some other microeconomic process in a particular bit of economic history.

    It is two very different things to say (1) that the Austrian business cycle theory machinery doesn’t explain all of what needs to be explained in a particular episode, versus saying (2) that the ABCT microeconomic machinery is empty, contradictory, causally incoherent, i.e. is bad economics.

    Scott writes:

    “I was planning a post on my overall view of Austrian macro, but Bill may have saved me the trouble, as the paragraph starting with “Critics of” in his 3:30 post is exactly my view. The phrase “of little quantitative significance” exactly explains my view of late 2006 to mid-2008, an overbuilt housing sector gradually losing resources to other sectors, subtracting about a point each quarter from RGDP growth. Then after mid-2008, sharply falling NGDP growth, WHICH IS COMPLETELY THE RESPONSIBILITY OF MONETARY POLICY, caused the current crises, which has cost trillions in bailouts, stimulus, higher future taxes on labor and capital, the President running auto companies, etc. So the Austrians may be right about 2006-08, but most of the Austrian commenters seem to think that the “secondary depression” of 2008-09 is exactly the same problem, when I don’t think it is. It was avoidable even as late as mid-2008.”

  89. Gravatar of Greg Ransom Greg Ransom
    1. May 2009 at 21:57

    No one has done the historical research yet, but it’s fairly likely that Friedman was exposed to “Austrian” ideas on money, inflation, expectations, etc. at Mont Pelerin Society meetings over the years — so when some version of these ideas later show up in his own Chicago/Keynesian/”monetarist” constructs, it’s less than perfect accident. This is just a working hypothesis. As I say, no one has done the historical research on the Mont Pelerin papers to tell us much about this likelihood.

    Scott wrote:

    “David has strongly argued that it was Hayek, not Friedman, who was the real discoverer of the natural rate hypothesis.”

  90. Gravatar of Lao Tzu Lao Tzu
    2. May 2009 at 00:55

    StatsGuy,

    I’m no Austrian, but that’s the worst argument I’ve ever seen. Presenting that datapoint and claiming that Austrians can’t explain it, therefore Austrians are wrong, is ridiculous.

    Bretton Woods and a fiat currency regime are not exactly the only things that happened after WWII.

  91. Gravatar of Bill Woolsey Bill Woolsey
    2. May 2009 at 03:48

    Stats guy:

    “Austrian” critics of existing monetary policy don’t
    count the pre-Bretton Woods system as ideal.

    Really, I am surprised you would say that. Perhaps you
    are confusing this with another debate. Has Keynesian
    inspired active demand management stabilized the economy?
    When we compare the pre- and post- Bretton Woods system..

    Anyway, Austrians are always griping about monetary policy
    in the twenties. And I don’t know that there are any Austrian economists who think that monetary policy was suitable in the thirties (though, as Scott points out, with some arguing it was too expansionary and others that it was too contractionary, it is hard to characterize
    “the” Austrian view.)

    Was monetary policy ideal “pre-Fed?” What about the Bank of England?

    Anyway, the free banking faction of Austrian macroeconomics would see no net good coming from any central bank, however, they believe that other “micro” oriented bank regulations had negative macroecoomic ramifications. So, when the bank of england was contracting credit in response to financial crisis (building its reserves like every other bank,) that wasn’t an “ideal.” Not only was the banking of England creating problems for the world econmy, regulations that encouraged, or even mandated, unit banking hardly helped. Prohibiting banks from issuing notes on the same terms of deposits causes currency runs even when banks were trusted. Reserve requirements prevent banks from acutally using reserves during a crisis. (A bit like todays capital requirements.) On and on.

    The “hard money” faction instead would blame the entire problem on the failure of the government legal system to ban fractional reserve banking. My “favorite” theorists of this school, I presument, believe that free market courts and police would have stamped out the “fraud” that is fractional reserve banking.

    So, historical episodes with 100% resreve banking and a fully privatized gold coin standard. And good data.

    Historical episodes with a fully private gold coin standard and free banking, permitting especially option cluases and unrestricted branching, no reserve requirements, note issue on the same basis as deposit issue….. And good data.

    Frankly, I think that the favored Austrian reform proposals are almost as speculative as nominal income index futures targeting.

    Center left economists may think that all of their critics are reactionaries seeking a return to the status quo before they started “improving” things, but the reality is that libertarian economists are all about change. Just a differnet sort of change.

    I just can’t stop before mentioning that anyone who thinks that Austrian economists liked a Federal Reserve operating on the “real bills doctrine” is just not paying attention.

  92. Gravatar of Bill Woolsey Bill Woolsey
    2. May 2009 at 05:03

    Ransom:

    I suppose that the explanation that I am too stupid to understand Austrian macro is always possible, but it is difficult for me to just take more intelligent people like yourself on faith. If it is just beyond my comprehension, I guess I will just have to go with simple explanations that I understand.

    You are mistaken that I fail to see disequilbrium processes in the market ecnomic system due to monetary changes. There may be ones that I cannot undestand that are only perceived by smarter people like yourself, but I can see some.

    I also can see equilibrium processes, and I see little evidence that some smart folks (like yourself) are taking them into account.

    And, by the way, my first exposure to “macro” was the Austrian Theory of the Trade Cycle. The notion that I am unable to get beyond previously existing macro concepts that I was already using to understand macroeconomic phenomenon is absurd.

    No, you must stick with the theory that I was too stupid to understand the Austrian macro I was taught. Then, later, I learned some other, easier to understand version of Macro, and because of my limited mental abilities, I found it more persuasive.

    For what it is worth, there is a theory of “quasi-rents” that is all about the heterogenous nature of capital goods and how changes in the demand for the specific products they are used to produce are imputed back to their values. It is quasi-rent rather than rent because as new capital goods of a particular type are produced or old ones wear out and are not replaced, the quasi-rents go away. Now, even if my explanation of quasi rents is confused, I hope this shows that “maintstream” economists do not always assume that all capital goods are homogeneous. I think quasi-rent comes from Ricardo, but Marshal harped on it a lot.

    While I probably learned the Austrian trade cycle theory at about the same time I learned about basic supply and demand, to the point where I am really not sure, I was primarily interested in microeconomics for some years of focused study before I became interested in macroecomics.

    How the price system, profit and loss signals and entrepreneurship shift production and resources is what I see as most important about economics. The invisible hand process is micro writ large. The concept of “round about methods of production” is central to my undestanding of interest rates, saving, investment, and the allocation of consumption through time. It would never cross my mind to think that his involves homogeneous capital goods.

    If you realize how messy the market process must be, then you will begin to see why I find your statements that interst rates must rise and some specific capital goods must be abandoned.. with so? Lots of things cause interest rates to fall and rise. Lots of things involve shifts in the patterns of supply and demand. Specific capital goods lose value for all sorts of reasons. And you are telling me that the changes in the value for specific capital goods because of changes in interest rates because of changes in money supply or demand explains the business cycle?

    What expactly happens when there is a decrease in saving? Describe the impact of that on the value of various heterogeneous capital goods and the output of consumer goods over time. Is that possible?

    Monetary institutions have persistent impacts of the allocation of resources. These persistent patterns aren’t going to be unchanging, but nothing else in the market economic system is unchanging. I don’t deny that there are disquilibrium processes, especially when we think about shifts between policy regimes. And, monetary mistakes have disequilibrium impacts on the allocation of resources too. But get a sense of proportion.

    Suppose there was some bone-headed monetary reform program that promised to end interest income and so benefit the working class. It involved creating money and lending it out in quantities sufficient to keep real interest rate at zero. What a fool policy. But, how exactly does it break down? Let’s not cheat and say that speculators of one sort or another just keep it from happening. Let us give the scheme the benefit of the doubt and assume that everyone will believe it will work. The whole allocation of resources, including its time struture, begins to develop as it would if interest rates were zero. What happens? How does it break down? How does the quantity theory reassert itself, so that this just causes a lower purchasing power of money, with the allocation of resources depending on the micro supply and demand conditions that will apply? We could imagine that the temporary impact on the allocation of resources would be extreme.

    Now, the analysis developed for that purpose may not be very applicable for explaining the problems that might exist in year 20 of a policy of 2% inflation. How much malinvestment is just waiting to cause problems if the policy is maintained? Oh, and we don’t give the benefit of the doubt so that the impact on the allocation of resources is maximized because the point of the policy was supposedly to have some maximal impact on the allocation of resources. The policy actually is not supposed to have any impact along those lines because the policy makers believe that inflation is neutral in the long run.

  93. Gravatar of ssumner ssumner
    2. May 2009 at 05:27

    One reason I am so slow here is that many comments are very long:

    Thruth, I also love the clarity of freshwater macro. But Austrian also has some advantages:

    1. Awareness of limitations of simple models
    2. Awareness of the importance of history, institutions, etc.

    I try to combine the best of the simple and complex:

    1. Be simple where it is appropriate (Unexpected NGDP shocks a major cause of cycles.)
    2. Be complicated where appropriate (my discussion of liquidity traps in previous posts.) Or the complex causes of NGDP shocks.

    Greg, I see your point, but “representative agent” can be appropriate for some purposes. I.e., the average consumer may respond to some policy in a certain way. But I agree many actual RA models miss important aspects of reality. By the way, I think you, me and Bill all agree on some of the problems with new classical models. I use ratex, but I am not a new classical economist either in terms of methodology, or market-clearly assumptions.

    Fundamentalist, On my previous replies (which came after you comment here) I addressed some of the issues with interest rate indicators of policy.

    I disagree that rising NGDP in depressions can only occur during hyperinflation (e.g. 1974, 1982.)

    I can’t follow your neutral inflation argument. First you seem to say it’s neutral if steady, but has no stimulative effect, and the very next line you say never neutral.

    It doesn’t matter whether capital goods “get the money first.” What matters is the amount of money. And anyway, they don’t “get the money first” this confuses money and credit, a common Keynesian error as well.

    Regarding the rapid growth in the money supply from the 1920s, here is the monetary base data to show how much money the Fed actually created:

    January 1920: MB = $6.909 billion
    January 1925: MB = $7.007 billion
    January 1929: MB = $7.155 billion

    Did someone tell me Rothbard made a big deal of monetary inflation in the 1920s? Where is it? Those are tiny percent increases

    BTW, every macro model predicts the capital goods industry will be much more volatile than other industries, not just the Austrian model.

    Regarding the “depression” of 1991 (which I’d call a recession) the rate of NGDP growth slowed dramatically, so the Austrian model adds nothing to my explanation.

    Greg, I don’t doubt the anecdote about Victorville homes is true, but the economy is pretty big. Kratina caused merely a tiny blip in GDP data. I still wonder how important a factor capital destruction actually is in the cycle. But I do agree business cycles can result in some very wasteful investment–no dispute there.

  94. Gravatar of ssumner ssumner
    2. May 2009 at 06:15

    azmyth, I agree, but to be fair to the Austrians Greg points out that they do emphasize bad policies like Smoot-Hawley and the NIRA.

    fundementalist, No stimulus effect is the desired effect of the smarter advocates of 2% inflation, Rather they hope for:

    1. Better micro efficiency as labor markets are more flexible (if nominal wages are nominally downwardly rigid)

    2. Less chance of a liquidity trap (which is a problem in the real world, although I don’t think it would be a problem with an ideal monetary system.)

    I also have my doubts about the investment prowess of the “superwealthy” For years I was told how smart the Harvard endowment was, and the hedge funds, etc. Now I read about Madoff, about Harvard losing a big chuck of their endowment, etc. Did the superwealthy suddenly unload their stock holdings before the October crash onto average people? I doubt it. I’ll bet even Warren Buffett lost a bundle. Obviously, ex post, richer people tend to have made smarter investments, but that doesn’t prove causation. It could have just been luck. Now if rich people continue to be smarter even after they are rich, that would prove something. Is there data that is more than anecdotal?

    Moldbug, “Robinson Crusoe” sounds a lot like the representative agent model Austrians like Greg criticize. BTW, my advisor Bob Lucas was famous for insisting that macro needed micro foundations. Are you referring to Friedman-era Chicago econ?

    I have a better explanation for December 2007. Tight money led to expectations of recession, which lowered yields. You can’t just say you don’t understand how Fed policy affects interest rates, and then talk with confidence (as many Austrians do) that rates were too low in 2003.

    The Fisher effect is a no-brainer:

    With higher inflation expectations the supply of loanable funds falls and the demand rises. Real interest rates are unchanged.

    Your 2019 bond example won’t work, because there are a finite number of such bonds. If they buy up them all there is no market price, and the other (commercial) bond yields will soar due to expected inflation.

    TGGP, Yes, I should have been clearer that I was implying Hoover tried to slow the wage adjustment. I don’t know the micro foundations of wage rigidity. Some theories are:

    1. Menu costs
    2. Money illusion

    I agree that this is a weakness of my model, but I still think wage rigidity is important (there is a lot of empirical evidence) and thus I use the assumption in my analysis.

    Jon, I think terms like “free market” in interest rates are misleading. I do understand what people mean, but I also think people subtly confuse interest rate targeting with price (or rent) controls. They are of course much different, as the Fed moves one side of the market until the equilibrium fed funds rate is close to their target. So there is no shortage or surplus as with price controls. Now you may be saying that you know all that. But let’s go a bit further. Under any monetary regime a change in the money supply may affect interest rates. Suppose the Fed had to increase the money supply 7% in 2003 to hit their FF target. Now suppose that they had no ff target at all, but just decided to increase the money supply 7% because they thought that rate was the most likely to provide macro stability. In that case the ff rate might still go to their target, as a side effect.

    I don’t know if any of this makes any sense, but my problem with ff rate targeting is not that it eliminates a “free market” in interest rates, as I think any monetary policy moves all sorts of prices (interest rates, exchange rates, etc.) away from the free market level they would be at with a stable money supply. But I also don’t favor a stable money supply, I want a money supply likely to produce 5% NGDP growth. So even my proposal moves interest rates and exchange rates away from where they would be with a constant money supply level. My criticism is more pragmatic, not dogmatic. I fear that interest rate, or money supply, or exchange rate targeting will not adequately stabilize NGDP growth. It will lead us astray, even though if done perfectly it could stabilize the economy just as effectively as NGDP futures targeting. But it won’t be done well, as we can see.

  95. Gravatar of ssumner ssumner
    2. May 2009 at 06:34

    Statsguy, Lao Tzu, and Bill,

    I basically agree with the latter two of you that you can’t disprove Austrian econ by simply pointing to the more stable business cycle since WWII. On the other hand I do think the relative stability of the economy after 1982 (until now) does suggest that a policy of low and stable inflation under fiat money is possible. So I do agree that history is relevant for the specific version of Austrian that views all fiat money as a disaster.

    FWIW, Bill has provided some of the clearest explanations of the various types of Austrian econ, so I support his view that he is highly competent to discuss these issues (certainly much more than I am.)

    Greg, That’s a fair point about the current crisis. I do think examples I provide can help give a sense of why I view NGDP targeting as so essential. At the same time there is Austrian discussion of the dangers of secondary depressions. So my comments might better be viewed not as a critique of Austrian econ in the abstract, but rather merely a critique of some specific judgments made my some specific adherent to that school of thought. So I think the thrust of your comment is correct. In the give and take of debate it’s hard to always adhere to that perspective.

    The remark about the Mt. Perelin Society is also interesting. As I said, David Glasner (who also knows a lot about this) also thinks Friedman stole from Hayek.

  96. Gravatar of fundamentalist fundamentalist
    2. May 2009 at 07:21

    ssumner: “Bill has provided some of the clearest explanations of the various types of Austrian econ, so I support his view that he is highly competent to discuss these issues (certainly much more than I am.)”

    Bill clearly doesn’t understand Austrian econ, as I and others have noted above.

    On the other hand, I don’t get the point of targeting NGDP. If NGDP falls, and the Feds increase the money supply, then all that happens is prices go up, taking the monetarist view. You have given the example of Zimbabwe, but what has increasing NGDP done for them? Is the purpose of targeting NGDP merely to keep people from defaulting on loans by paying them back with inflated dollas?

    Suppose you have a constant 2% price inflation going on for several years and 5% NGDP growth, but the real economy stumbles for some reason (maybe my one of mainstream’s infamous “shocks”). If real growth falls to zero, then the Feds will have to boost inflation to 5%. It doesn’t seem difficult to me for us to end up in stagflation again as we did in the 1970′s, or eventually to go the way of Zimbabwe. Targeting NGDP is nothing but a policy of inflation, and as Mises wrote, to get the effects of inflation that inflationists desire requires increasing the money supply at increasing rates. But if you keep up that policy, you eventually get hyperinflation.

    It’s true that most of the depressions since WWII have started with the Feds raising interest rates. But why did they? Because they feared that price inflation was getting out of hand. Targeting NGDP seems to say that you don’t care about the threat of hyperinflation.

    BTW, I think Hayek’s best book on the business cycle was “Profits, Interes and Investment” which seems to be ignored by most Austrians today. I have no idea why. But the main point of his book was that a single monetary shock of supplying too much money, via credit expansion (Austrians see very little difference in money and credit because they have exactly the same effects), is all that’s needed to get the business cycle rolling. Throughout his analysis, he keeps interest rates unchanged and demonstrates that the boom/bust cycle will occur anyway without any further monetary shocks. It’s all done with relative prices. Price theory is one of the weakest links in mainstream econ. Mainstream economists seem to think that prices don’t matter, that people don’t respond to changes in relative prices.

  97. Gravatar of Lao Tzu Lao Tzu
    2. May 2009 at 10:26

    ssumner: “On the other hand I do think the relative stability of the economy after 1982 (until now) does suggest that a policy of low and stable inflation under fiat money is possible.”

    Are you restricting this to consumer price inflation?

    And how much of this “low and stable inflation” was actually due to the proper management of fiat money in the US? And not due to the US simply exporting inflation abroad?

    If I recall correctly, Deng Xiaoping’s economic reforms for China began in 1978. Since then consumer goods have been increasingly produced in China and exported back to the US. China’s massive labor force has of course meant lower production costs and thus has kept consumer price inflation in check. Heavy industrial goods, durable goods, have been increasingly imported not only from China but from Japanese companies which also have utilized low cost labor in Asia. Even Japanese auto companies with factories in the US employing American labor have been able keep costs lower by using non union labor, avoiding legacy costs, etc. And within the US, outsourcing and the threat of outsourcing seems to have kept wage inflation and therefore consumer price inflation in check.

    And we all know that much of Chinese, Asian, ME, export dollars have been recycled back into the US, propping up the dollar and keeping consumer price inflation lower still.

  98. Gravatar of Bill Woolsey Bill Woolsey
    2. May 2009 at 12:04

    fundamentalist:

    A policy of 5% nominal income growth will not get the effects of inflation that Mises claims will require an ever accelerating inflation rate. That argumement works if the goal of is to lower real interest rates, increase capital accumulation, and raise real wages. What if that isn’t the goal?

    If there is a negative real shock, a nominal income target of 5% will result in more than 2% inflation. But it would not create ever accelerating inflation.

    If it were really true that any inflation begins to cause a reduced money demand (because an expectation that the past inflation will continue in the future), then maintaining the nominal income target will require that the money supply grow less (or even shrink) to offset that effect. If people understand what is going on, then the inflation will be understood to be temporary and they will expect inflation to return to the long term trend.

    Mises more or less assumes that the purpose of money creation is to lower real interest rates compared to what they would otherwise be. The point of this is to increase capital accumulation and raise real wages compared to what would have been.

    What if that isn’t the purpose of the policy? That certainly isn’t the reason Scott favors a 5% nominal income target. It isn’t so that real interest rates will be lower, that real wages will be higher, than capital accumulation will be greater. If it has any such effect in the long run or the short run, it is irrelevant to the policy.

    Stories that take the form of, the real interest rate starts to rise, so to keep the real interest rate down and avoid unemployment in capital goods industries, even more money creation occurs.. No.. Intead, the real interest rate rises. Consumption spending rises faster than capital goods spending. The time structure of production shortens. Maybe output grows more slowly for a time. The 5% nominal income target involves more than 2% inflation for a time.

    And eventually, that is all over. There is saving, capital accumulation, capital advance, population growth–real income rises. The 5% nominal income growth results in 2% inflation more or less. Maybe. If malinvestments have to be worked out–so be it. If there is a bad harvest, production grows more slowly for a time. The 5% nominal growth rate results in more inflation for a time.

    That is how it works.

    The goal is simply that the quantity of grow and a greater less rate (or shrink if needed) so that nominal income grows 5% per year. Given whatever impact, if any, these money growth rates would have on the allocation of resources, along with everything else that might impact the allocation of resoources–the market deals with that.

    If your framework is limited to explaining how efforts to keep real interest rates low or the accumulation of capital high, or whatever, then you are always going to be at a loss to explain something else.

    As I said before, the answer to the claim that maintaining the malinvestments require ever increasing inflation–just say no. Let the malinvestments liquidate while maintaining modest levels of inflation. Let real interest rates rise. Let the capital structure adjust. If you really targeting inflation, let nominal income grow more slowly for a time so that lower growth in real income and output are consistent with the inflation target.

    When targetting nominal income, then inflation does do up for a time, if real income grows more slowly for any reason. But let real interest rates rise. Let capital goods industries shink. Don’t cause ever growing monetary inflation (which implies ever more rapid growth in nominal income) in a futile effort to keep real interest rates low and maintain some pattern in the allocation of resources (some particular time structure of production.) \

  99. Gravatar of Jon Jon
    2. May 2009 at 12:12

    Scott:
    They are of course much different, as the Fed moves one side of the market until the equilibrium fed funds rate is close to their target. So there is no shortage or surplus as with price controls. Now you may be saying that you know all that… But I also don’t favor a stable money supply, I want a money supply likely to produce 5% NGDP growth.

    Yes, I agree that the Fed’s behavior is not akin to price controls. I do not, however, believe that the dichotomy you present is correct. Indeed, the reason that the gold cover ratio was never ’1′ is that the money supply (of notes) can be elastic even when the supply of metallic currency is fixed. The question then becomes whether one could design a mechanism such that the variable demand for settlement funds can be meet (elastically) without distorting the social time-preference.

    Mises is aware that the demand for money varies and should be meet:

    … but also within single years, quarters, months, and weeks, even single days, there are considerable fluctuations in the leve of the demand for money. The transactions involving the use of money are concentrated together at particular points of time; and even where this not the case, the demand for money is differentiated by the practice on the parts of buyers of settling their share of transactions on particular dates… a similar effect arises from the custom of not paying wages and salaries daily, but weekly, monthly, or quarterly….

    But he also argues (rightly) that the money supply is not that which exists in the narrow sense but that which exists in a broad sense:

    The cash balance held by an individual need by no means consist entirely of money. If secure claims to money, payable on demand are employed commercially as substitutes for money being tendered and accepted in place of money, then individuals’ stores of money can be entirely or partly replaced by a corresponding store of these substitutes.

    Indeed this is the (supposed) point of the banking system:

    The present-day organization of the money, clearing, and credit system is said to have the tendancy to balance out variations in the quantity of money and render them ineffective, and so to make prices as far as possible independent of the stock of money.

    So, I don’t think he denies the utility of this system, but he does doubt (for instance) that the arguments of the Banking School are correct.

    Thus there is no such thing as an automatic adjustment of the quantity of fiduciary media in circulation to fluctuations in the demand for money without an effect on the objective exchange value of money. Consequently all those arguments are ill founded which seek to deny practical significance to the quantity theory by reference to the alleged elasticity of the circulation of money. The increase and decrease of the stock of fiduciary media in a free banking system have no greater natural connection, direct or indirect, with the rise and fall of the demand for money in the broader sense, than the increase and decrease of the stock of money have with the rise and fall of the demand for money in the narrower sense. Such a connection exists only insofar as the credit banks deliberately try to bring it about.

    In some sense Mises is decidedly against free banking as such.

  100. Gravatar of Greg Ransom Greg Ransom
    2. May 2009 at 14:31

    Bill — all I’m saying is that economics is hard and that there are no “magic” arguments against micro-violating uses of macro, there are just micro economic arguments followed very closely. I’m arguing against your suggestion that “magic” is involved in disputing some uses of macro. It isn’t. It’s just plain old micro, but not easy stuff for anyone.

    I’m not saying anything about your own abilities as a microeconomist, which I have no opinion on as I haven’t closely studied your work.

    Bill wrote:

    “I suppose that the explanation that I am too stupid to understand Austrian macro is always possible, but it is difficult for me to just take more intelligent people like yourself on faith. If it is just beyond my comprehension, I guess I will just have to go with simple explanations that I understand.

    You are mistaken that I fail to see disequilbrium processes in the market ecnomic system due to monetary changes. There may be ones that I cannot undestand that are only perceived by smarter people like yourself, but I can see some.”

  101. Gravatar of Devin Finbarr Devin Finbarr
    2. May 2009 at 14:42

    Bill and Fundamentalist-

    The key point you are both missing is the mechanism of inflation matters a heck of a lot. If the government inflated by 5% every year by simply printing money and using that money to subsidize loans, it could do so sustainably for an indefinite amount of time. Yes, interest rates would be artificially low, yes, it would be a subsidy to borrowers. But as long the policy was consistent and did not change, it would be sustainable forever.

    But in practice, the Fed does loan in a very unsustainable way. I’ll adopt Moldbug’s term from above – rather than printing the money directly and loaning it, the Fed engages in a “Bagehot scheme”. In modern days, the amount of the inflation is always much bigger than the amount of money printed. Thus, as Moldbug pointed out, the banking system in practice is something of a market manipulation scheme. And these schemes do require continuing forward momentum, or else they collapse.

  102. Gravatar of azmyth azmyth
    2. May 2009 at 15:13

    Scott – “…to be fair to the Austrians Greg points out that they do emphasize bad policies…”
    I agree completely. Austrian economics is methodologically individualist. This explains the Crusoe economics and the level of difficulty pure Austrian theory has in dealing with a policy recommendation like “target NGDP”. NGDP has no meaning to an individual, only to a group. It’s also far more aggregated than anything Austrians would be comfortable with. You’re dealing with aggregated prices and aggregate subjective values of a staggering range of products in a diverse economy. I don’t think you are going to get a clear answer out of Austrian econ because it’s not set up to deal with your question. The Austrian Buddhist would say “mu”.

  103. Gravatar of Gabriel Durazo Gabriel Durazo
    2. May 2009 at 16:56

    moldbug: “It is to economics as a cuckoo is to a robin – a parasite that stole the name of economics, and ate its body.”

    Uhh… what? I’ve tried wikipedia to no avail. What exactly does this analogy mean?

  104. Gravatar of ssumner ssumner
    2. May 2009 at 17:26

    Fundamentalist, You say,

    “Bill clearly doesn’t understand Austrian econ, as I and others have noted above.

    On the other hand, I don’t get the point of targeting NGDP. If NGDP falls, and the Feds increase the money supply, then all that happens is prices go up, taking the monetarist view.”

    I’m not sure it’s a good idea for you to be criticize others for not understanding Austrian econ, and then go out and say that about monetarism. Have you ever read Friedman and Schwartz’s “Monetary History of the US?” They think more NGDP would have prevented the Depression.

    And Austrians see no difference between money and credit?

    Regarding accelerating inflation, you seemed to simply repeat the same point without addressing my response at all.

    Famous Austrians like Hayek and Selgin favor NGDP targeting, but when I favor it I am called an “inflationist.”

    Lao Tzu, Imports have had only a small impact on inflation, and any impact they did have could easily have been compensated for through monetary policy. BTW, post-1982 inflation is still a bit higher than I would have liked, but much better than in the 1970s. Wage inflation, (an entirely domestic part of the picture) fell sharply after the 1970s.

    Bill, I agree, and would add that because NGDP growth averages 3%, if some years inflation is higher than 2%, in others it will be lower. So fundamentalist’s point has no long run relevance. Even during the “stagflationary” 1970s real GDP growth averaged close to 3%, so inflation would have been about 2% under my plan, and about 0% under your plan. What was the actual rate in the 1970s?

    Jon, I probably didn’t make my point very well. I actually agree with Mises about free banking. It doesn’t automatically keep prices stable. You need monetary policy to do that. I never meant that Mises favored a fixed money supply, either, rather it was a thought experiment for people to reconsider what a “free market” means. As long as there is a Fed, there is no free market in money. The Fed has a monopoly on the supply of base money. When they change the supply it can impact interest rates (in many ways). My point is it makes no sense to ask the Fed to stop interfering in the free market and let markets set interest rates, or exchange rates, or price levels, or anything. What is a free market in money? It is a system with no Fed at all. The minute they monopolize base money, no other monetary market is free, whether “targeted” or not. Maybe this is still unclear, I wonder if anyone sees what I am driving at here. Perhaps there’s a better way to make my point.

    Devin, You and several others keep saying things that are flat out wrong:

    “In modern days, the amount of the inflation is always much bigger than the amount of money printed. Thus, as Moldbug pointed out, the banking system in practice is something of a market manipulation scheme. And these schemes do require continuing forward momentum, or else they collapse.”

    No. During most years the rate of inflation is lower than the money growth rate, often much lower. And inflation has trended lower for 30 years, not higher, with just a few small blips up now and then. I don’t mean to single you out, as I have the impression that a lot of commenters just throw out assertions without checking the data. I suggest anyone truly interested in monetary econ should look at the various data sources. You will find lots of interesting things, such as that inflation tends to be lower during what Austrians sometimes call “easy money periods” i.e. low interest rate periods.

    azmyth, Yes, some Austrians don’t like to talk about abstract concepts like NGDP. But as I said above, some very good ones like Hayek and Selgin want to target it. I am playing around with the following idea, anyone have any thoughts:

    I have written several papers arguing that the gold standard evolution to fiat money led Keynesian economics to evolve from old to new Keynesianism. Fiat money (usually) makes monetary policy more powerful than fiscal policy, and leads to shifting Phillips curves, Fisher effects, etc. I ignored Post-Keryneianism, not knowing much about it, but isn’t PK sort of like old Keynesianism? With its distrust of abstract concepts like using monetary policy to target inflation? (A idea more feasible under fiat money regimes.)
    Has something similar occurred in Austrian econ? Is a George Selgin the Austrian version of new Keynesian? At home in a fiat money world where the Fed can target nominal aggregates. On the other hand are the more strict gold standard/abolish the Fed Austrians more like the old Keynesians, with policies that match a gold standard world (such that any attempt at nominal targeting will eventually result in disaster.) Some people throw out the term “vulgar Austrian.” Just thinking out loud are they to people like George Selgin what post-Keynesians are to new Keynesians? The true believers? People who think about macro in ways that are very distant from a fiat money world?

    My schema doesn’t apply to monetarists, as they have always been fiat money types. Although Fisher didn’t call it that, his “compensated dollar plan” was pure fiat money. In the old days Quantity Theorists like Fisher were actually to the left of Keynes.

    First post to exceed 100 comments!! [Memo to myself--no more Austrian posts during exam weeks.]

  105. Gravatar of StatsGuy StatsGuy
    2. May 2009 at 20:37

    I rather think Bill has a decent grasp of (at least one version of) the Austrian Story.

    But I am not objecting to the entirety of Austrian theory (or theories) based on one datapoint (it’s really 200 datapoints). I am objecting to the (dominant) Austrian assertion that active intervention by central banks tends to make things worse (possibly at an accelerating pace). For example, when Hayek was explaining why 1929-1933 was so severe in spite of what seemed like stable (or possibly declining) price levels leading up to 1927, his apparent explanation was that the depression wouldn’t have been so bad if the Fed hadn’t embarked on policies that delayed the liquidation process after the crisis kicked in.

    So I posed the question:

    “If the Austrians are correct that govt currency management worsens the business cycle, then exactly how does one explain the noticeable reduction in volatility?”

    The suggested answers seem to be:

    1) Something else happened contemporaneously (Lao Tzu points to Chinese liberalization giving us cheap goods; I would alternatively suggest US exports of dollars as the dollarization process accelerated – but these things didn’t happen until ~1980 or later, and I doubt they were of sufficient magnitude. The dollarization of foreign economies may help explain ssummer’s observation that inflation was lower than the money growth rate.)

    2) Regardless of what happened after 1940, the Austrians didn’t particularly like the active Fed policy before that either…

    Perhaps, but the (new) Fed only came into being in 1913, and so had no role in the extreme volatility leading up to the 20th century (1873-1879 being the most vicious example).

    Although the theoretical arguments behind the Austrian distaste for an active central bank seem plausible, I struggle to find the empirical evidence. Even pointing to the 1970s, and our discovery of NAIRU (if it holds true), doesn’t change the point. I’d rather have lived through the 1970s and early 80s than 1873 or 1893. Let alone 1929.

    ON A SEPARATE NOTE:

    Recent events have somewhat overshadowed fractional reserve banking. The key issue being that loans move to deposits fairly instantaneously, and most money is electronic. Thus we have LIBOR, where banks can loan money to each other cheaply using overnight rates during boom times (until a confidence shock kills that scheme) to even out discrepancies between deposits/loans that may exist in the system. The Fed discount window further relaxes deposit constraints. That is why the current debates are focusing more on capitalization, not fractional reserve lending. This is not a defense of fractional reserve banking, merely a note that it is somewhat fading as an issue of critical import given the current system design and the electronic (on-deposit) nature of money. The real limitation on bank lending is capital.

  106. Gravatar of Jon Jon
    2. May 2009 at 21:11

    Scott: fair enough. This discussion has been quite interesting; its been good occasion to page through Mises’s Theory of Money and Credit again. It really is an under-appreciated work.

  107. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 02:53

    No. During most years the rate of inflation is lower than the money growth rate, often much lower.

    I should have been more clear. What I meant was that in most years the growth of broad money (M2, M3) was much faster than the growth of base money ( M0). Having the growth of credit continually outpace the supply of actual base money backing the credit is not a recipe for long term stability.

  108. Gravatar of JKH JKH
    3. May 2009 at 04:00

    As an interested observer of this discussion, I’d be grateful if someone can offer a view as to how Kondratieff connects to or fits into the Austrian story, if at all.

  109. Gravatar of Vasile Vasile
    3. May 2009 at 04:06

    ssumner: Austrians see no difference between money and credit?

    Scott, a more precise wording would have been that Austrians see not difference between money and _bank credit_. What are checking accounts if not money? And how about credit cards?

    The broadest definition of money is “claims for good”. The unfortunate reality is that under current arrangement of things, “broad money” is not a naturally scarce good. But it is still being exchanged for real scarce goods.

    Hence Uncle Millie (and yours) ideas of putting an artificial constraint on the amount of “claims for goods”. But for this to work… Well, this is already a long thread, and I just say that I’m skeptical.

    And it will still mess up with relative prices. Even if the CPI stays rock-stable.

  110. Gravatar of ssumner ssumner
    3. May 2009 at 04:40

    Statsguy, I agree with almost all of your observations. BTW, I believe Hayek changed his view later in life and came to believe the Fed should have been more expansionary in the early 1930s.

    Jon, Thanks Jon, I’ll try to look at Mises some time.

    Devin, Just the opposite. The base increased 10-fold between 1975-2007, M1 only about 5-fold. Since then the gap has been even wider with the unusual base increase last fall. The St. Louis Fed has all the data

  111. Gravatar of Bill Woolsey Bill Woolsey
    3. May 2009 at 04:44

    Finbarr:

    The notion that base money backs credit is confused.

    You need to think about credit markets without fractional reserve banking. Could credit expand? Could in contract? What determines interest rates. How do they impact the allcation of resources. What could make them change? What happens to the allocation of resources when they change.

    You also need to understand “liqidity” creation independent of money creation. It _is_ confusing because economists sometimes identify liquity with money wheras it has another meaning of easy to sell.

    Then, you will be ready to undestand how the creation of monetary liabilities by banks could cause disruptions in credit markets.

    With that approach, you will be less likely to fall into the confusion that all “credit” is all based upon “base money”

    If you learn about fractional reserve banking, and then just assume that the process of lending money into existence is what all credit is about, it is easy to go wrong.

    Also, there is a good bit of popular explantions of the Austrian Trade Cycle theory which is just marketing for gold salesman. (All financial markets are about to collapse, buy gold.)

  112. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 07:25

    Devin, Just the opposite. The base increased 10-fold between 1975-2007, M1 only about 5-fold.

    Did you read what I said? I wasn’t talking about M1! Although to be more clear honest, even M2, M3, MZM, are bad measures of broad money expansion. Really the relevant number is the total amount of maturity mismatched credit. Unfortunately, no one is keeping track of that number.

    The notion that base money backs credit is confused. You need to think about credit markets without fractional reserve banking.

    I was making a point specifically about the special case of fraction reserve banking – http://blogsandwikis.bentley.edu/themoneyillusion/?p=1094#comment-2516 Whenever the money supply expands via continuously increasing the maturity mismatch of lending, you are asking for trouble. Overtime, the probability of a bank run approaches one.

    You also need to understand “liqidity” creation independent of money creation. It _is_ confusing because economists sometimes identify liquidity with money whereas it has another meaning of easy to sell.

    It’s actually confusing because the folks at the Fed and Treasury lie about what liquidity means. (I’m not sure if they are lying just to the public or are lying to themselves too). But all the “toxic assets” that are “illiquid” and selling at “fire sale” prices are all perfectly liquid. A market exists, the banks are just in denial that the prices really are pennies on the dollar.

  113. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 08:39

    StatsGuy-

    If the Austrians are correct that govt currency management worsens the business cycle, then exactly how does one explain the noticeable reduction in volatility?

    A third answer is that it’s just an artifact of data collection. I have no idea how the GDP numbers you presented were calculated. I’m sure that the methodology in 1900 was very different than in 2008. Also keep in mind that Austrians have a lot of criticism of the pre-Fed banking system too. The National Banking Acts in the 1860′s basically forced all U.S. banks to maturity mismatch, and its maturity mismatching that causes the business cycle.

  114. Gravatar of Bill Woolsey Bill Woolsey
    3. May 2009 at 08:49

    Finbarr:

    Failure to match maturies and create liquidity could (and would) exist without fractional reserve banking. Failing to match maturies does transfer interest rate risk. It should impact the allocation of resources–in particular allowing more round about methods of production. Changes in the willingness of people to share that risk will, therefore impact the allocation of resources. So what? There is no avoiding the trade off between risk and return.

  115. Gravatar of david glasner david glasner
    3. May 2009 at 09:17

    Scott, About Hayek, while I do believe that Hayek quite adequately anticipated Friedman’s basic result about the natural rate of unemployment by ten or more years, and I have no doubt that Friedman was aware that Hayek had made a similar argument, I am not prepared to say that Friedman stole it from Hayek. But the facts are what they are and other people can characterize them as they wish. The passage from Hayek that Jon quoted from seems to be from a paper (probably a lecture) that Hayek delivered in the 1970s, by which time he had largely abandoned the notion that malinvestments lengthening the structure production really matter for explaining business cycles. Hayek actually spent years trying to rigorously ground the simple Misesian business cycle model in the updated capital theory presented in the Pure Theory of Capital. He gave up and published the Pure Theory of Capital without integrating any real businss cycle analysis. He then went on to the next stage of his career and never really looked back at his earlier business cycle stuff. He did publish Three Elucidations on the Ricardo Effect in JPE 1968, but its main point was to offer a new graphical version of the Ricardo Effect point and to make clear that a fully expected policy of monetary expansion would not be neutral. But he did not argue that it would not be unsustainable. Hayek’s greatest contributions, especially the Economics and Knowledge paper, which clarifies the notion of equilibrium (i.e., compatibility of expectations) in terms of which a business-cycle theory has to be compared and contrasted were related to but definitely independent of his earlier business cycle theory. Once he got to that stage of analysis, he could dispense with the business cycle theory which had very little explanatory power of its own.

  116. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 09:40

    Failure to match maturies and create liquidity could (and would) exist without fractional reserve banking.

    There are a variety of ways that lenders can mismatch maturities, even outside of orthodox fractional reserve. But mismatching maturities is always highly unstable, and the end result is either a bank run or a bail out (or an informal bailout – the Fed guaranteeing loans, providing “liquidity” etc).

    I don’t understand what point you are trying to make about interest rate risk. Moldbug explained very clearly above the problem with maturity mismatching and you don’t seem to have understood or addressed his points.

  117. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 13:22

    Scott-

    I don’t see any evidence that maturity transformation has anything to do with the modern business cycle. I explains neither supply shocks, nor demand shocks.

    This is an incredible statement. After witnessing a crisis that originated out of the complete meltdown of the banking sector, I cannot understand how anyone could miss the connection. You do not even have to be an Austrian to believe this. The President of the Richmond Federal Reserve made a speech detailing the role of the maturity transformation in creating the crisis. Or you can read the same thing from Megan McArdle or Diamond Dybvig.

    Here is my version of how the crisis unfolded:

    1) For many decades, and especially from 2000-2088, the “shadow banking” sector was engaging in maturity transformation on a massive scale. There are trillions of dollars stored in money market funds. Most of those accounts are considered risk free, and near zero maturity. Yet in reality, behind those money market funds were 30 year mortgages securities paying interest rates of 5%. Through modeling, risk insurance schemes, and tranching, banks managed to back supposedly liquid, risk free money market funds with these mortgages.

    2) Maturity transformation combined with broken risk modeling created an infinite money loop. A bank makes a 30 year loan, the money filters back into a money market fund, and then it gets loaned out for 30-years again, etc, etc. With no reserve requirements and anyone with a pulse fitting the borrowing risk models, there was little limiting the amount of loans the banks could make.

    3) Whenever you have an influx of new money chasing an inelastic supply of goods, prices shoot up. Housing prices, stock prices, oil prices, gold prices, etc. all went up over the last decade.

    4) Note also that the created credit did not just get used to buy housing. Corporations used short term CP to initiate long term projects. Private equity guys used leverage to bet on stocks and commodity futures. Corporate buyout guys used the cheap credit to buy up public companies and take them private. Moguls accessed revolving credit accounts to buy sports teams. Consumers took out home equity lines to remodel their homes.

    5) The danger of the maturity mismatching schemes is the bank run. The money market funds were backed by 30 year mortgages paying 5% interest. No one who owned shares in the fund desired to own such a loan. Had they actually wanted to lend out money for 30 years, they would have desired a much higher rate of interest, perhaps 10, 15, or even 20%. As a result, in bank run, the fund must liquidate and sell the loans to people who actually intend to hold the loans to maturity. In such a case, the net present value of the loan is much, much lower. A bank run can happen at any time – it is caused by a loss of confidence. As soon as a person suspects the bank cannot fulfill its promises, everyone will run to get their money out.

    6) In 2007 real estate prices started to fall in the sun states. The market could not sustain prices so far above the cost of production. All of the credit models were based on the idea that sustained collapse in housing prices could not happen. These models started to fail.

    7) As prices fell, the models started to break. Banks found it harder to pass of these securitized mortgages. Now they could make less new mortgages. With less credit entering the system, prices started to fall more.

    8) Credit did not seize up instantly. Rather, as specific SIV’s and leveraged funds started to fail, credit gradually slowed. Losses piled up a gradually over the course of 2007, but in many areas of banking credit creation was going on as fast as ever.

    8) By early 2008 losses were piling up. News came out that Bear Stearn was insolvent, the Fed was forced to step in and bail out their creditors. Other banks were forced to mark their assets to market, and now they could meet capital requirements for continued lending.

    9) With the lack of new credit, prices of housing fell more. With falling home prices, losses at banks piled up even more. The process that caused a feedback loop propping up asset prices, was now deflating. Demand for housing securities dried up. By mid-2008 lending standards were now much, much higher. While interest rates for prime borrowers were still pretty low, interest rates for subprime borrowers had gone from ~8% to infinity. Available credit for corporate buyouts, hedge fund leverage, etc. also started drying up. NGDP was now falling.

    10) The absence of new money buying up assets caused prices to start falling. Hedge funds now had to liquidate holdings to meet margin calls. This caused prices to fall more, setting off a new round of margin calls and selling.

    11) In September, Lehman collapsed with no bailouts for anyone. Their commercial paper was held by prominent money market funds. These funds broke the buck. This scared investors who thought money market funds were risk free, and a bank run started. Immediately the Fed stepped in and provided guaranteed loans and stopped the bank run in its tracks. But now all demand for commercial paper dried up. Nobody wanted their money market money to be backed by IOU’s that matured in 30 years. As a result, during this time demand for notes backed by the full faith and credit of the U.S. government increased dramatically. Demand for treasuries and dollars spiked.

    12) The Lehman bankruptcy set off a new round of write downs, margin calls, and liquidations. Hedge funds and university endowments were losing money fast, and now had to liquidate in falling markets in order to pay cash obligations. Retail investors saw which way the wind was blowing and started selling off. The stock market crashed.

    14) Thanks to the magic of maturity transformation a few hundred billion dollars of losses in sub-prime mortgages resulted in trillions of dollars of price declines in the “toxic assets”. The losses were the trigger that caused the bank run. The assets went from being priced based on the idea of flipping to someone else, to a price based on holding to maturity. The latter price is dramatically lower.

    15) Some economists have estimated that the total drop in price of all dollar denominated assets to be 50%. With asset prices deflated and credit dried up, NGDP continued to fall. People’s balance sheets were ruined. With stock market savings and home equity wiped out, they had to stop spending. Consumer spending on durables and luxuries started dropping dramatically. Universities had lost a great deal of money and needed to do hiring freezes. Companies had to do layoffs. Unemployment started to rise. The recession was in full swing.

    The problem the Fed has is that its standard tools for reflating are actually rather limited. As the crisis deepened the Fed kept dropping the Federal Funds rate. But the effects of this are limited because most lending is not constrained by reserve requirements. Capital requirements and the availability of borrowers that fit the models are both limiting factors. In fact, the entire Shadow Banking sector – which is where the deflation is coming from – was in large part outside of the Fed’s control.

    In order to actually reflate the Fed has to adopt unorthodox methods, which for various reasons, it has been slow to do (the reasons for slowness are both political, legal, and economic. The basic problem is that in order to reflate the Fed must give someone money. But if the Fed is seen as printing money and giving it to Wall St banks, there will be hell to pay. So the Fed’s actions are limited by the fiction that it is investing in distressed assets rather than bailing out the banks). So far the most effective emergency actions have been aimed at preventing catastrophic deflation – such as creating the money market lending facility and the commercial paper lending facility. Without those facilities, the crisis would be much, much worse.

  118. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 15:33

    Scott and Bill-

    A core difference between the Austrians and everyone else, is that the Austrians have a model in their heads for how an ideal financial system should operate. Unfortunately, our current system is far from such a model. Thus the Austrians often have difficultly in applying their insights to our financial system as it is. And the monetarists and the Keynesians are so caught up in the details of our Rube Goldberg finance system that they cannot even relate to the simplified models that the Austrians present.

    But I think it can be instructive to envision what a sound financial system should look like. Such a system should have no bank runs and no business cycle. After we look at the system, we can see if we can apply its lessons to the issues that Scott has been discussing. So here is my model for an ideal financial system:

    a) All societies need an intermediary good. A person raises a chicken. He trades the chicken for an intermediary good, stores the good for a period of time ( anywhere from minutes to decades) and then trades the intermediary good again for food or clothes or whatever he desires. The intermediary good has no direct utility, its use is as a store of value. As a result, it is important to use the same good that everyone else is using. If you trade your goat for some wampum shells, but the rest of your tribe is uses beads as money, have just lost out. No one will accept your wampum beads.

    b) A monetary system is most stable when precisely one good is used as an intermediary good. If more than one good is used, a slight shift in the relative prices causes momentum to shift towards the good appreciating in price, causing it to appreciate even more. In a very short time, the entire herd has settled back onto using exactly one good. Settling on exactly one good as money is a Nash equilibrium.

    c) A financial system also has instruments that are flows of money ( bonds and stocks). A person will buy a flow because he has no urgent use for his intermediary good, and thus he is willing to trade $1 now for $2 in ten years.

    d) Bonds and stocks are priced at equilibrium when the people buying them buy purely based on risk, time preference and anticipated cash flows. Stocks should be bought based on anticipated dividend payouts over a long holding period. As Mark Cuban says, “The best stock to buy is the one you never have to sell.” Bonds should be bought based on holding until maturity.

    e) When bonds and stocks are priced based purely on cash flow, risk, and time flows, the chance of a bubble affecting the broader economy is minimized. If stock prices rise dramatically, but dividends are stable, I do not increase my spending, because I am spending based on dividends. When the prices crash down I do not lower my spending, because I am spending based on dividends. The bubble does not affect aggregate demand. If I have equity in money market fund, I spend based on yield, not on market price. So if the price of the stock in fund drops, it does not bother me because the payout remains the same. If the fund made bad investments, then I do incur losses. But my losses are equal to the total defaults. In our current banking system of maturity mismatching, a few hundred billion dollars of default losses caused trillions of dollars in losses do to collapsed bond prices. This would not happen if everyone always priced bonds based on time preference.

    f) In the ideal financial system a typical portfolio would be something like: 1) 20% cash in a bank vault, 40% CD’s, 10% stocks, 30% annuity/mutual funds ( which would hold stocks and bonds). There would be no risk of losing money in a bank run, since the cash would be in 100% reserve accounts. The CD’s would all be maturity matched. Stocks would mainly be held by annuity funds, trust funds, and endowments that would hold the stocks forever and payout based on dividends.

    g) An intermediary good (or a better word for it – collectible) is valuable because everyone else believes it is valuable. When people value stocks based on the idea of selling it someone else, and not based on dividends, the stock is trading as a collectible. When people hold a bank note that trades at par for a $1, because everyone believes the bank note is worth a $1 ( and even though the underlying asset is an IOU for $2 payable in 30 years) then that bank note is trading as a collectible. When the bank note is trading at a price where the buyer actually intends to hold it for 30 years, the bank note is priced as a flow. The difference between these two prices can be called the collectible premium

    h) In my ideal financial system no goods would trade with a collectible premium. The only collectible would be actual dollars. This is because we established at point b) that a financial system is most stable with precisely one collectible.

    i) Since dollars absorb all demand for an intermediary good, there can never be a sudden demand shock. In our modern financial system demand shocks happen when a “money substitute” like a bank note or commercial paper goes from trading as a collectible to trading based on hold to maturity. This could never happen in my financial system since all bonds are priced on hold to maturity.

    j) With no monetary shocks possible, there would be no recessions or depressions. There would be no business cycle ( really the business cycle should be called “the banking cycle”.

    So the above is the vision of a perfectly stable financial system. Nothing like this exists in the world today. There are a few random examples of financial systems close to this, but they were a long, long time ago ( Gibraltar, the Hamburg, 17th Century Amsterdam)

    But the vision can still be applied to the current crisis. Scott, you and I are in agreement that the Fed must act to reflate. But we disagree on the basic method of reflation. There are two basic ways of inflating: a) increasing the supply of money or b) reducing the demand for money.

    Here the above example becomes instructive. A financial system is most stable when dollars absorb all demand for a collectible/intermediary good. Thus inflating by reducing demand for money will result in continued disequilibrium and macro instability. The collectible premium would spread across a number of goods – stocks, housing, gold, etc, and the constant fluctuations in the collectible premium and the demand for money would continue to cause panics and crises.

    Thus I would like to see the demand for money maintained at its current level ( or even increased, there is still a collectible premium embodied in stocks and housing prices). To avoid catastrophic deflation, the supply of money should be increased to meet this increased demand for money. The Fed and Treasury should then act to maintain demand for money at this new high level ( perhaps by limiting or even banning maturity mismatching). The best way to avoid a popping bubble is to never blow the bubble in the first place.

    Modern academic economics could be called “disequilibrium economics”. It describes a world where a collectible premium is spread across dollars, treasuries, bank notes, money market shares, M0, M1, M2, stocks, gold and real estate. Economists note that whenever the herd starts running towards any one of these goods, bad things happen. Thus the goal of the Fed is to keep the ball exactly on the peak of the hill, not rolling in any direction. When the ball starts rolling towards gold or housing, the Fed tightens and pushes it back towards the middle of the hill. When it goes too far towards dollars, the Fed eases and tries and push the ball back to the center of the hill. I say, let the ball roll off the hill, all the way down, towards actual dollars. Only when dollars absorb all demand for collectibles will the financial system be at a stable equilibrium, rather than perched in a state of extended disequilibrium.

  119. Gravatar of Greg Ransom Greg Ransom
    3. May 2009 at 16:34

    David — just for the record I don’t buy this canned history of Hayek’s intellectual biography. The record is contradictory and complex, to say the least — and the ideas in Hayek’s 1937 paper can be found in his _Pure Theory_, and his _Pure Theory_ contains a Part IV which is the sketch of the implications of his production goods / interest work for the next step into monetary theory and the trade cycle.

    Read Hayek’s 1978 UCLA interviews or his 1970s papers on Keynes, and you’ll see Hayek didn’t abandon much of anything. His ideas got more complex, but they weren’t abandoned.

    “Scott, About Hayek, while I do believe that Hayek quite adequately anticipated Friedman’s basic result about the natural rate of unemployment by ten or more years, and I have no doubt that Friedman was aware that Hayek had made a similar argument, I am not prepared to say that Friedman stole it from Hayek. But the facts are what they are and other people can characterize them as they wish. The passage from Hayek that Jon quoted from seems to be from a paper (probably a lecture) that Hayek delivered in the 1970s, by which time he had largely abandoned the notion that malinvestments lengthening the structure production really matter for explaining business cycles. Hayek actually spent years trying to rigorously ground the simple Misesian business cycle model in the updated capital theory presented in the Pure Theory of Capital. He gave up and published the Pure Theory of Capital without integrating any real businss cycle analysis. He then went on to the next stage of his career and never really looked back at his earlier business cycle stuff. He did publish Three Elucidations on the Ricardo Effect in JPE 1968, but its main point was to offer a new graphical version of the Ricardo Effect point and to make clear that a fully expected policy of monetary expansion would not be neutral. But he did not argue that it would not be unsustainable. Hayek’s greatest contributions, especially the Economics and Knowledge paper, which clarifies the notion of equilibrium (i.e., compatibility of expectations) in terms of which a business-cycle theory has to be compared and contrasted were related to but definitely independent of his earlier business cycle theory. Once he got to that stage of analysis, he could dispense with the business cycle theory which had very little explanatory power of its own.”

  120. Gravatar of Greg Ransom Greg Ransom
    3. May 2009 at 16:43

    This is bogus, Devin. Austrian macroeconomist Gerald O’Driscoll, Jr. actually worked for the Fed and was a senior economists for Citibank. Hayek closely studied the Fed in the early 1920s. Mises and Hayek were up to their eyeballs in the day-to-day facts of the Austrian banking system in their work on the post-WWI financial treaty.

    Lawrence White and George Selgin have written a number of books on real works banking arrangements.

    You’re making up stuff Devin.

    Devin:

    “A core difference between the Austrians and everyone else, is that the Austrians have a model in their heads for how an ideal financial system should operate. Unfortunately, our current system is far from such a model.”

  121. Gravatar of Devin Finbarr Devin Finbarr
    3. May 2009 at 17:40

    Greg-

    Read my comment again. I did not claim that no Austrians understand the current financial system. I said that the end Austrian goal of sound money would look very different than our current financial system.

    I also said, “Thus the Austrians often have difficultly in applying their insights to our financial system as it is.” That is “often” – not always. Certainly many Austrians (like O’Driscoll or Moldbug) have excellent insights into the current financial system. But I do read a lot of articles and comments from Austrians who do not understand the details of our “soft money” financial system, and thus have a lot of trouble applying Austrian insights in a constructive way. Perhaps you have different reading habits than mine so you do not encounter these types of Austrians as much.

  122. Gravatar of Greg Ransom Greg Ransom
    3. May 2009 at 17:50

    Devin — point well taken. I misunderstood you. A hazard of blog comments sections.

  123. Gravatar of ssumner ssumner
    4. May 2009 at 04:49

    Vasile, I find the monetary base definition of money to be the most useful. Look at my reply to Nick in the new post on “Being There” and the post it links to.

    Devin, You say, “Did you even read what I said. I wasn’t talking about M2.” You are right, I am very overworked right now and slipped up on the Ms. Just to review for the readers:

    1. You told me prices always rose faster than money in the modern world. I told you the opposite was true.

    2. Then you changed your tack and told me you actually meant the aggregates grew faster than the base. I first checked M1, and found it grew much more slowly than the base.

    3. Then you reminded me it was M2. I just check M2, it has also grown more slowly than the base, even excluding the recent ER spike.

    4. Now you tell me that M2 is also not important.

    Maybe you might save me a lot of time by checking your facts, and deciding what variables you think are important, before you send me off on one wild goose chase after another. I am a patient person, but there are limits. And given your track record, I’m not sure your outraged tone is justified.

    David, Thanks for clarifying.

    Devin#2, I have spent months trying to show that the financial crisis did not cause the collapse in AD. Rather tight money caused the AD collapse, which made the financial crisis much worse. If you don’t agree, then fine. But tell me what is wrong with my view.

  124. Gravatar of StatsGuy StatsGuy
    4. May 2009 at 05:39

    Just a comment on securities mismatch…

    Banks have two core functions:

    They perform retail services (checking, loan payment management, underwriting services, etc.).

    They absorb intertemporal risk (against their capital cushion). Alternatively expressed, they borrow short and lend long, using their collateral to absorb losses.

    Maturities mismatch is, therefore, inherent in their nature – regardless of the existence of fractional reserve banking or not. Finbarr is quite right (and I am quite not an Austrian).

    The presence of maturities mismatch (e.g. securitization of intertemporal risk) is essentially the privatized creation of short term money (credit) that is collateralized by long term money (like a CDO). Relying on growth in the private money (credit) supply to keep the money supply at a constantly growing size is thus identical to relying on a steady exponential growth in credit (without shock).

    This is why every time I hear the oft-abused phrase that “we need to restore credit because credit is the lifeblood of the modern economy” I nearly choke. Whatever happened to public money?

    As Finbarr notes, private money/debt is theoretically limitless, but practically limited by a few things:

    1) Supposedly, capital-asset ratios. Maybe. Hopefully.

    2) Velocity – just how fast can loans be converted into deposits (including, now, money markets per Finnbar’s point). If velocity were infinite (e.g. a loan were made the instant money was deposited, and loan credit was deposited the instant it was received), we can have infinite money from any nominal starting point.

    So let me restate this: The failure of the government to control velocity means that we have a money supply that is significantly privatized and endogenous, limited only by demand for money and willingness of capital-holders to absorb intertemporal risk (and default risk, of course – which is linked to intertemporal risk through inflation and asset resale/liquidation values). This can exist in ANY banking system – but the fundamental change today is not moving off the gold standard, it’s the electronic existence of money. It’s all about velocity…

    Remember the endogenous theory of money (I think ssummer posted on it…)?

    Unless the govt. controls velocity (and ideally creates more exogenous/public money to help stability), then the system is vulnerable to shocks. You can control velocity on the money side, or on the real-world side (e.g. limiting types of loans and who can borrow and for what), or on both. Targeting NGDP without controlling velocity is challenging (to say the least) – and to ssummer’s credit, he has called this point and suggested mechanisms to increase control over velocity.

    But with uncontrolled purely private money, it’s a cyclical ponzi scheme. We’ve seen this so many times! (Remember the Wildcat banks?)

    Yet without any privately created money (debt), all investment must be generated through cash or through public investment – which theoretically could work through sophisticated equity securitization, but at some point detailed equity securitization starts to look like debt. (What, exactly, is a preferred share?)

    In other words, if you think private allocation of investments and consumption is more efficient than public allocation, you probably want some amount of intertemporal risk-sharing, you therefore need some private money (debt).

    But if you do not regulate the creation of private money you face moral hazard, because it’s the public that suffers if private money supply collapses to prevent economic disaster, and they will therefore seek to replace private money with public money.

    (And, dear friends, there are two main arguments against public rescue:

    a) Fairness, based on the Austrian interpretation of justice and contracts – I will not comment on this, save to note that in the real world the Austrian version of fairness often rewards those individuals who entered the ponzi scheme early and got out early.

    b) Long term stability/efficiency. This is where I raise objections – where exactly is the data supporting that assertion? Certainly not in the chart that I’d linked earlier.

    Which is why many rational folks are in favor of saving the system now, and regulating it in the future.

  125. Gravatar of JKH JKH
    4. May 2009 at 08:02

    A bit back, I asked if anyone could shed light on the influence of Kondratieff on Austrian thinking, if any.

    Some may be interested in the following article I uncovered by Rothbard on the subject:

    http://www.lewrockwell.com/rothbard/rothbard44.html

    (The word evisceration comes to mind)

  126. Gravatar of Bill Woolsey Bill Woolsey
    4. May 2009 at 08:44

    Finbarr:

    Maturity mismatches always result in bailouts or runs?

    No, they can result less profit and evenlosses for the debtor or bankruptcy and shared losses for both creditor and debtor.

    Many things that happen in the market economy result in capital losses for the owners and, if bad enough, bankruptcy and losses shared by creditors.

    Building a financial theory on the implicit notion that no one should ever lose money is faulty.

    What is important is why such losses impact total expenditure in the economy. They don’t have to.

  127. Gravatar of Bill Woolsey Bill Woolsey
    4. May 2009 at 10:50

    Ransom:

    The logic of the inflation tax works through the budget contraint. (It is a micro concept.)

    To maintain real balances in the face of inflation, nominal balances must increase, implying a difference between the nominal incomes and expenditures of those utilizing money. (That is the budget constraint part.) This is true for everyone holding money balances.

    Resources are freed up to produce whatever it is that the money issuer wants. Like other taxes do. This is pretty standard micro.

    The segniorage created by inflation is a very “micro” approach to inflation.

    The reduction in the demand for real balances creates an excess burden from inflation. But there is a transfer of resources between those holding money (using money) and the money issuer.

    This is sustainable. If the revenue from the tax is earmarked to subsidize lending, then there is a sustainable impact on credit markets.

    By the way, this would generally count as undersirable, like taxing apples and using the proceeds to subsidize bananas. It is sustainable. There will be fewer apples grown and more bananas. People will eat less apples and more bananas. But the marginal apples sacrificed are worth more than the marginal bananas gained. Bad, but sustainable. Of course apple orchards will shrink and banana groves expand. But this is “optimal” given the tax and subsidy scheme.

    With the inflation tax, the loss in well being from holding less money balances would be worth less than the gain in future consumption from added captital accumulation because of the subsidy. (Or whatever it is that the credit subsidy actually expands. Maybe it is current consumption financed by credit card debt.)

    My view is that some of the “but new money must enter the economy somewhere” at least partly the revenue impact of the inflation tax.

    I recognize that there are simultaneous disquilibrium proceses that go on. But I think there is a tendency among Austrians to mix them up. For example, you didn’t seem aware of the inflation tax logic. A process that means that inflation is _of course_ not neutral. As Wagner said, that is the point.

    It is not the case that monetary disequilibrium must impact the allocation of resources. I think the fact that money can be lent into existence is important, and I think it is easy to see how monetary disequilibrium can lower interest rates. But, this should result in less saving and more consumption–even without consumer loans. Lower interest rates makes saving less attracive, and so rather than use income to accumulate bonds, households can spend on consumer goods. The households allocation of income between consumer goods and the various assets they could by are impacted by the price. A very micro argument.

    Even if bank loans all go to firms buying capital goods, (which I grant they should find more profitable because loans are at lower interest rates,) the change in market prices can impact sectors of the economy independent of where the “new” money flows.

    How can both consumer and capital goods production be expanded at the same time? There are shortages. The economy is in disquilibrium. Why is there any impact on the allocation of resources?

    I’m am not claiming that there can’t be any such impact. Maybe investment is more sensitive to changes in interest rates than consumption. Maybe capital goods producers respond to rising demand faster than consumer goods industries.
    But it isn’t obvious how the disequilibrium works out.

    And, of course, as Cowen and Caplan point out, anyone who does purchase capital goods or make any adjustment in capacity because of this disequilibrium are making entrepreneurial mistakes. And if they don’t, then what happens is that the supply curves all get really steep–really inelastic. And so, the increase in demand here or there, result in higher prices. This reduces real balances and clears up the disequilbirum created by the increase in nominal balances.

    Now, if this is persistent, so that people must reduce other expenditures to rebuild real balances in a persistent fashion, then this is sustainable, the inflation tax.

  128. Gravatar of Devin Finbarr Devin Finbarr
    4. May 2009 at 15:55

    Scott,

    Apologies for the wild goose chase. Measuring monetary inflation is a hard problem. Due to Cantillion effects the consumer CPI numbers often do not present an accurate gauge. And given Wall St’s propensity to create new forms of maturity mismatched credit, the money aggregates are always a step behind. When I’m trying to measure monetary inflation I usually look at a combination of different numbers ( MZM, credit growth statistics, housing prices, oil prices, gold prices, farmland prices, S&P 500 revenues, NGDP ). No one number is definitive.

    I have spent months trying to show that the financial crisis did not cause the collapse in AD. Rather tight money caused the AD collapse, which made the financial crisis much worse.

    I’ve read most of your old blog posts, but I think you’re still missing the connection.

    When money is tight it can either be because of a sudden increase in demand for money or because of a sudden decrease in supply. If you say there was a demand shock for money, I agree. But then you also say, “I don’t see any evidence that maturity transformation has anything to do with the modern business cycle.” But I presented you with a detailed argument, with links to actual Fed speeches corroborating my case, that shows exactly how a popping maturity transformation bubble causes a demand shock for paper backed by the Full Faith and Credit of the USG.

    Can the Fed counteract a demand shock with the correct monetary policy? Sure. Did the Fed commit a sin of omission by not easing enough? Yes. But it’s still important to see analyze and understand the role of maturity transformation in creating the demand shock.

    In your analysis, was money tight because of a fall in supply of money or a rise in demand?

    If it was a fall in supply, well, what is the evidence for that?

    If it was a fall in demand, what caused the sudden rise in demand for money? And remember, we are talking about a massive, massive demand shock. The price of the world’s wealth has dropped in half. What accounts for such a massive demand shock?

  129. Gravatar of Devin Finbarr Devin Finbarr
    4. May 2009 at 16:23

    Bill and Scott-

    In a sound financial system, when a borrower wants to borrow for five years, he finds a lender to lend for five years. The lender forgoes use of the money for five years, and the borrower can use the money to pay for real goods. The lender incurs various risks. There is default risk. There is risk that the returned money might have lost its purchasing power over five years.

    In a maturity mismatched system there is a new risk. The original lender lends for one years. The bank then turns and lends out the money for five years. In order to pay off the original lender, the bank must find a new lender. Thus there is a new risk – roll over risk. Notice, that this risk is very similar to the risk of a Ponzi scheme. The Ponzi scheme must always find a new investor to pay off the old one. I like Moldbug’s terminology in calling a maturity transformation a Bagehot scheme. And like a Ponzi scheme, the Nash equilibrium is for the scheme to collapse.

    Building a financial theory on the implicit notion that no one should ever lose money is faulty.

    Of course. Risk taking and loss is an essential part of an economy. But that a sound financial system should try to avoid Ponzi schemes. And – I believe – it should also avoid Bagehot Schemes.

    And currently, the government does even worse than allow Bagehot schemes. It either promotes the schemes or winks and nods at them. Through “too big to fail”, liquidity guarantees, lender of last resort facilities, these schemes grow very, very large. The “too big to fail” policy simply made it so that the Bagehot scheme got very, very large, and then proceeded to collapse. Now the Fed is left bailing it out.

    What is important is why such losses impact total expenditure in the economy. They don’t have to.

    The short term lender in a Bagehot/MT scheme desires to own risk free short term money. When the MT scheme collapses, he rushes to convert his bank notes or money market shares to actual dollars. This causes a demand shock for money. Thanks to wage rigidities, debt contracts, and the non-neutrality of deflation, this demand shock causes a recession or depression. Get rid of Bagehot schemes, get rid of depressions.

    Maturities mismatch is, therefore, inherent in their nature – regardless of the existence of fractional reserve banking or not.

    No, in theory a bank could match a borrower who wanted to lend for five years with a borrower with who wanted to borrow for five years. No maturity mismatch is needed. Unfortunately, we have not had banks like that in a long time.

    Yet without any privately created money (debt), all investment must be generated through cash or through public investment

    In a sound system of finance, money is not debt. Money is a collectible, an intermediary good. Debt means an obligation to pay a quantity of good X at time Y. If money is the debt obligation, what is the good X?

    In a sound system of finance, investment can be generated by maturity matched lending.

  130. Gravatar of david glasner david glasner
    4. May 2009 at 18:06

    Greg, Obviously, I was oversimplifying drastically in a short posting meant to be at least mildly provocative. You are right that the Pure Theory of Capital contains a concluding section which sketches out some implications of his approach for business cycle theory, but my recollection of that part is that he was operating at a very high level of abstraction (almost metatheory) and was not committing himself to a particular theory of business cycles, just as his 1937 paper does not commit him to a particular theory of business cycles. What we find in the later Hayek (say, Road to Serfdom and after) is a theory which says no more than that monetary stimulus causes a misallocation of resources because, as long as inflation is unanticipated, it makes a variety of enterprises more profitable than they would otherwise have been because factor costs have not risen to reflect the unanticipated inflation. This widening of price cost margins induces an increase in profits and output and employment and you get a boom. But as inflation becomes anticipated as it must, factor costs rise to eliminate the excess profit margins. At that point, reducing inflation becomes contractionary because profit margins are depressed as factor costs reflect an expected inflation that exceeds realized inflation. Again, this is the kernel of Friedman’s natural rate hypothesis, and it follows naturally from Hayek’s early business cycle theory. What is missing is any reference to a lengthening of the capital structure or an increase in the average period of production. Hayek’s work on the Pure Theory of Capital convinced him that those concepts were simply unworkable if not entirely meaningless, and he almost never referred to them in the last 50 years of his life. It never ceases to amaze me that Austrians who characteristically reject the notion of a price level or other macro-aggregates, because they are statistical constructs not market phenomena, don’t seem to have the slightest problem with an average period of production, which is not only an artificial statistical average, but it is based on a notion of orders of production that is itself based on a uniform linear progression of inputs to outputs that has no connection with actual production relationships in the economy. There are certainly complex intertemporal relationships within an economy which are often important analytically, but the simple Austrian schema of higher and lower orders of production is not even remotely plausible as an empirical representation of reality. Hayek understood that, and that’s why he stopped talking in those terms. And that’s what I think he abandoned.

    David — just for the record I don’t buy this canned history of Hayek’s intellectual biography. The record is contradictory and complex, to say the least — and the ideas in Hayek’s 1937 paper can be found in his _Pure Theory_, and his _Pure Theory_ contains a Part IV which is the sketch of the implications of his production goods / interest work for the next step into monetary theory and the trade cycle.

    Read Hayek’s 1978 UCLA interviews or his 1970s papers on Keynes, and you’ll see Hayek didn’t abandon much of anything. His ideas got more complex, but they weren’t abandoned.

  131. Gravatar of Greg Ransom Greg Ransom
    4. May 2009 at 18:53

    David — I agree that Hayek set aside what he’d always considered to be a mere short cut — the “average period of production” macro-aggregate of Bohm-Bawerk.

    But I’d suggest the fact that Hayek rejected the “average period of production” is not the same as concluding that Hayek rejected higher and lower orders of production, or contended that such things don’t exist in the economic. His _The Pure Theory of Capital_ was all about thinking about such things without problematic macro-aggregates of the “average period of production” sort.

    David wrote:

    “the simple Austrian schema of higher and lower orders of production is not even remotely plausible as an empirical representation of reality. Hayek understood that, and that’s why he stopped talking in those terms.”

  132. Gravatar of Devin Finbarr Devin Finbarr
    4. May 2009 at 19:56

    Oops, I meant to address my last comment to Bill and StatsGuy.

  133. Gravatar of Jon Jon
    4. May 2009 at 22:08

    Tyler Cowen seems to be taking a few quiet shots at the Austrians. One of my ever present frustrations at critiques of the Austrian position is the misstatements of the theory.

    For instance Tyler links to the following description:

    According to the theory, the business cycle unfolds in the following way. The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.

    First as I’ve noted previously, Mises does not argue that ‘low-rates’ are a problem or that expansion of fiduciary media necessarily causes low-rates. So the author has already begun on a loose limb.

    Lets read what Mises actually says:

    An increase in the stock of money in the broader sense caused by an issue of fiduciary media means a displacement of the social distribution of property in favor of the issuer… One thing must be clearly stated at this point: there is no direct arithmetical relationship between an increase or decrease in the issue of fiduciary media on the one hand and the reduction or increase in the rate of interest…

    I’ve given more complete quotes before… now then:

    The redistribution of property causes individual economic agents to take different decisions from those they would otherwise have taken. They allocate them differently between present (consumptive) employment and future (productive) employment. This may give rise to a an alteration in the size of the national subsistence fund if the alterations in the uses to which the goods are put by the individual economic agents do not offset one another but leave a surplus in the one direction or the other.

    We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks…

    Here is the core:

    A lengthening of the period of production is only practicable, however, either when the means of subsistence have increased sufficiently to support the laborers and entrepreneurs during the longer period…

    The situation is as follows: despite the fact that there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production… A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. The time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so shows up the rate of the accumulation of capital. The means of subsistence will prove insufficient to maintain the laborers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods… The market prices of consumption goods rise and those of production goods fall.… That is, the rate of interest on loans rises again, it again approaches the natural rate…

    Mises here is of course expressing that the induced inflation causes a rise in the real-rates at a given nominal load-rate.
    So it isn’t that the investments made are themselves bad or unwise. Indeed, the investments spurred on by depressed interest-rates may be in themselves successful. The process isn’t “unsustainable” because the investments are idiotic. But rather the process results in inflation.

    However much the banks may endeavor to extend their credit circulation, they cannot stop the rise in the rate of interest. Even if them were prepared to go on increasing the quantity of fiduciary media until further increase was no longer possible (whether because the money is use was metallic and the limit had been reached below which the purchasing power of the money-and-credit unit could not sink without banks being force to suspend cash redemption, or whether because the reduction of the interest charged on loans had reached the limit set by the running costs of the banks), they would still be unable to secure the intended result…

    Thus banks will ultimately be forced to cease their endeavors to underbid the natural rate of interest. That ratio between prices of goods of the first order and of goods of higher orders which is determined by the state of the capital market and has been disturbed merely by the intervention of the banks will be approximately reestablished….

    A precise reestablishment of the old price ratios between production goods and consumption goods is not possible, on the one hand because the intervention of the banks has brought about a redistribution of property, and one the other hand because the automatic recovery of the loan market involves certain of the phenomena of crisis, which are the signs of the loss of some of the capital invested in the excessively lengthened roundable processes of production. It is not practicable to transfer all the production goods from those uses that have proved unprofitable to other avenues of employment.

    Notice in the above that liquidation is not an essential element because the investments have not for the most part gone bad. Thus no violation of the EMH has happened. Nor is the liquidation a meaningful event of the theory.

    One of the striking things about the Austrian theory is how modest it is. It does not attempt to explain mass unemployment (depressions). Rather it attempts to explain a pattern of cyclic boom in the capital goods market. That is, it attempts nothing more than to explain why an expansion of fiduciary media in excess of ‘demand’ can induce inflation rather than merely inducing an inflation-free expansion.

  134. Gravatar of Bill Woolsey Bill Woolsey
    5. May 2009 at 02:32

    Jon:

    I presume all of these quotes from the the Theory of Money and Credit. I have read that book twice, but not recently. Anyway, I think you need to understand that the Austrian Trade Cycle Theory is more ambitious that what you suggest.

    Mises himself lectured on it in the late twentieth century. Rothbard was a student of Mises.

    One issue you point to continues to be a contention between the Free banking and 100% reserve banking Austrians. The early Mises, like Hayek, and the free bankers insist that increases in the quantity of money that match increases in the demand to hold money do not cause malinvestment. The 100% reserve banking Austrians insist that any increase in the quantity of money leads to malinvestment and cite the “later” Mises.

    Also, the general explanation about the malinvestmnets might not be bad is that this would just be pure luck and they are likely to be bad.

  135. Gravatar of david glasner david glasner
    5. May 2009 at 05:18

    Greg, you are right I was exaggerating. However, the kernel of truth in my exaggeration remains that Hayek did become disillusioned about the possibility of articulating a meaningful and relevant theory of business cycles in the terminology of the Bohm-Bawerkian theory of capital (which Carl Menger dismissed as one of the greatest blunders in the history of economics) which is what gives the theory its distinctive Austrian flavor in contrast to other similar monetary overinvetment theories. And despite my dismissive comments about Austrian business cycle theory, I accept that there is a kernel of truth in it as well and that there can be sectoral imbalances about which the Austrian theory provides some insight which have a cyclical element (but which was more pronounced under the classical gold standard, when gold flows imposed a constraint on credit expansion, than under a fiat currency). From this useful, but modest if not marginal, insight into business cycles (or at least the expansion and upper turning point of the cycle) under the gold standard, Austrians flatter themselves on their comprehensive understanding of all the causes and properties of all the phases of all business cycles including the Great Depression. But when asked to explain the severity of the Great Depression in light of the comparatively modest (by historical standards) monetary expansion of the 1920s, the reply seems to be something like “Herbert Hoover was an idiot.” Well, I don’t need the Austrian theory of business cycles to figure out that Herbert Hoover was an idiot.

  136. Gravatar of ssumner ssumner
    5. May 2009 at 05:21

    Sorry, I will have to do this one later. BTW, Tyler Cowen linked to an interesting Austrian piece a few days ago, which made some good points critical of Austrian trade cycle theory. But I also thought some of the current Austrians had good arguments that he was ignoring recent progress in the field.

  137. Gravatar of Jon Jon
    5. May 2009 at 09:28

    Bill:

    I have to admit that my focus on the Theory of Money and Credit could be regarded as a bit ahistoric. The canonical interpretation is that Mises’s TMC only hints at the ABCT and that Hayek’s later “Prices and Production” is the first full-development.

    But this has not been my experience. Chapter 19 of the TMC contains the important intellectual elements. The central contribution is to explain why the stimulus tends to be inflationary. Once you have that, you have the whole argument and need not consider the probity of the investments made during the boom to arrive at the same conclusions.

  138. Gravatar of Greg Ransom Greg Ransom
    5. May 2009 at 10:25

    David — Roger Garrison doesn’t do this, Lawrence White doesn’t do this, Steve Horwitz doesn’t do this.

    What’s with all the false statements and over the top exaggerations?

    I don’t get it. Murry Rothbard is dead.

    David.

    “I accept that there is a kernel of truth in it as well and that there can be sectoral imbalances about which the Austrian theory provides some insight which have a cyclical element .. From this useful .. insight into business cycles .. Austrians flatter themselves on their comprehensive understanding of all the causes and properties of all the phases of all business cycles including the Great Depression.”

  139. Gravatar of Greg Ransom Greg Ransom
    5. May 2009 at 10:30

    Scott — as I pointed out at the time, Tyler was ignoring arguments already published by Hayek in 1929.

    It was bad explication of theory — on top of bad history of eocnomic thought.

    And Tyler should know better because I called him on the same thing in the mid-1990s at a session of the Austrian Economics Society meetings.

    Some of these arguments Tyler once knew — he has a very, very brief footnote referencing Hayek’s 1929 work in his own book on macro.

    Scott wrote.

    “Tyler Cowen linked to an interesting Austrian piece a few days ago, which made some good points critical of Austrian trade cycle theory. But I also thought some of the current Austrians had good arguments that he was ignoring recent progress in the field.”

  140. Gravatar of Greg Ransom Greg Ransom
    5. May 2009 at 10:35

    David — more false exaggeration. I’m guessing you know it too.

    Robert Higgs has a bit more to say than “Herbert Hoover was an idiot”. Ditto White, Selgin, Horwitz and others.

    I have to ask again, what’s up with this sort of exaggeration?

    David writes:

    “when asked to explain the severity of the Great Depression in light of the comparatively modest (by historical standards) monetary expansion of the 1920s, the reply seems to be something like “Herbert Hoover was an idiot.””

  141. Gravatar of david glasner david glasner
    5. May 2009 at 12:13

    Greg, Murray Rothbard is dead, but his spirit lives on at the Mises institute and lewrockwell.com and assorted other Austrian establishments of higher learning. I know and like and respect Roger Garrison, and Larry White, and Steve Horwitz, and George Selgin and Israel Kirzner, who is a truly phenomenal scholar and a great man, but it’s Tom Woods that is writing the best-sellers these days, and he is now the public face of Austrian economics, and I think it is an outrage that he is getting away with it.

    Perhaps I exaggerate, but I don’t agree that it is false to point out that the Austrian business cycle theory cannot account for the Great Depression. My comment about Herbert Hoover was a short-hand (and, I must admit, to me moderately amusing) way of making the point that attributing the severity of the Great Depression to misguided policies, like raising taxes and wages after the crash, may be perfectly valid, but it has precisely nothing to do with the Austrian theory of business cycles. I have met Robert Higgs only once or twice in my life, and I have no reason to doubt that he is a fine scholar as well as the above-mentioned, but just because he is (I actually don’t know if he is or not) an Austrian economist does not mean that he has provided a specifically Austrian explanation of the Great Depression. I deny that such an explanation exists, and if it did, it would be wrong.

  142. Gravatar of Jon Jon
    5. May 2009 at 15:50

    The 100% reserve banking Austrians insist that any increase in the quantity of money leads to malinvestment and cite the “later” Mises.

    The rudiments of this position are in the TMC. Indeed this appears in the 1912 edition:

    It has gradually become recognized as a fundamental principle of monetary policy that intervention must be avoided as far as possible. Fiduciary media are scarcely different in nature from money; a supply of them affects the market in the same way as a supply of money proper; variations in their quantity influence the objective exchange value of money in just the same way as do variations in the quantity of money proper. Hence, they should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods. The possibility of causing temporary fluctuations in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious consequences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel’s Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.

    Ah but what of fluctuating demand for money, he answers optimisitically:

    At first it might appear as if the execution of such radical measures would be bound to lead to a rise in the objective exchange-value of money. But this is not necessarily the case. It is not improbable that the production of gold and the increase in the issue of bank credit are at present increasing considerably faster than the demand for money and are consequently leading to a steady diminution of the objective exchange value of money. And there can be no doubt that a similar result follows from the apparently one-sided fixing of prices by sellers, the effect of which in diminishing the value of money has already been examined in detail. The complaints about the general increase in the cost of living, which will continue for a long time yet, may serve as a confirmation of the correctness of this assumption, which can be neither confirmed nor refuted statistically. Thus, a restriction of the growth of the stock of money in the broader sense need not unconditionally lead to a rise in the purchasing power of the monetary unit; it is possible that it might have the effect of completely or partly counteracting the fall in the value of money which might otherwise have occurred.

    So you see, Mises offers a prescription of gentle inflation. So why wouldn’t he propose a CPI standard? Well he is quite strongly opposed to the concept of estimating price inflation. It seems to him impossible to do it right (in 1912)–an attitude which he would carry forward into old age.

  143. Gravatar of TGGP TGGP
    5. May 2009 at 16:15

    it’s Tom Woods that is writing the best-sellers these days, and he is now the public face of Austrian economics, and I think it is an outrage that he is getting away with it.
    Other Austrians like Woods’ “Meltdown”, even if they disagree on 100% reserve. Even though it was light and polemic, I enjoyed his P.I.G to American history as well (Horwitz didn’t, but I can’t find what he said about it anymore).

  144. Gravatar of ssumner ssumner
    5. May 2009 at 17:48

    OK, you guys know way more about Austrian than I do, so I’ll skip over some of the debates amongst yourselves. But a few observations:

    Devin, I admit that with lots of threads and incredibly long ones, I cannot concentrate on each person’s theory, especially in areas I find so boring it makes my hair hurt (like banking.) Now I suppose if banking is key to the business cycle, that gap in my knowledge would be a big problem. But I don’t think it is. The big recessions have non-banking causes in my view:

    1920-21. Tight money by the Fed–sharply reduced the base to restrain inflation.

    1929-30. Tight money by the Fed to stop the stock market boom.

    1931-32 Yes banking was important, but it only collapsed because of the severity of the Depression.

    1937-38. Deflation caused by gold hoarding.

    1981-82 Volcker disinflation policy of Fed

    2008 Yes, banking was the trigger, but I still think Fed errors of omission were the key.

    I don’t know enough about banking to know the relative importance of MM and leverage and all the other issues. My focus is on what I do know, which is that monetary policy has almost unlimited ability to steer expected future NGDP growth. And if we do so the economy will be far more stable. And we are not using that power effectively.

    One other question. You keep talking about crises and bailouts. I don’t recall many between 1934-1990. Am I right, and if there weren’t many banking crises, why not?

    Greg, Question–I am new to this. When you refer to “Tyler” do you mean his views, or the blog he links to. Because people don’t always agree with everything they link to. I saw references to Tyler and Caplan–was that recent?

    David, I also thought your “Hoover was an idiot” was amusing, and I also took it as shorthand for all his bad policies. But I might go even a bit further. Even though there seems to be almost universal agreement on the right that Hoover’s tax, tariff, wage fixing, ag. price supports, etc, etc, were bad, that’s not the whole story. NGDP fell more than in half, and in about the worst way possible. Not 1% a year for 50 years. Not all in one year (as in 1920-21 to a lesser extent) but over 4 brutal years. And that wasn’t really Hoover–it was the Fed (and the other weaknesses in the international gold standard.) Even here Hoover is partly to blame, as he supported Fed policy.

    So what is my point? It is that your Hoover is an idiot comment may understate the problem of Austrian Depression analysis. Yes, they have very good analysis of a variety of Hoover and FDR policies that hurt the economy’s supply side, and perhaps were ahead of some others in that area. But I don’t know whether they have added much to the question of how NGDP fell more than 50%. All those Hoover policies tell us why the 50% resulted in more RGDP losses than needed, but not why NGDP itself fell. So my question is this. Do they have an analysis of why NGDP fell sharply that is analogous to what is in your 1988 book, or my various published papers? Or is it comparable to F&S? Or to Temin? I honestly don’t know the answer. Greg tells me the Austrians agree that the money growth of the 1920s cannot fully explain the Great Depression. I have argued there are two Great Depressions, a nominal one (explained by gold standard defects we both agree) and a real one which was partly standard sticky wage/price AS/AD, and partly “idiotic” Hoover and FDR policies. We all know about the idiotic policies by now, but where are the Austrians in terms of the fall in NGDP? Anyone else can also answer my question.

    Once school’s out in a few days I try to respond more fully to comments. Perhaps we can have a more focused Austrian post on a specific issue. And I’ll do more reading.

  145. Gravatar of david glasner david glasner
    5. May 2009 at 19:11

    Any Austrian who is honest (if you want I can provide a partial list of those excluded by that condition, but basically it includes every Austrian who invokes the writings of Hayek, Haberler, Machlup and Robbins in the 1930s that advocated deflation as a cure for the depression even though each of them subsequently repudiated that advice) will admit that the Austrian theory of business cycles has nothing (underscore nothing) to say about the behavior of NGDP after the upper turning point. Hayek recognized, even in his early work, the possibility of a “secondary deflation” that is triggered by the initial downturn, but that is an add-on to the theory, not the theory itself. And on his first try, Hayek unfortunately got it wrong, terribly wrong, in buying into the idea that you could have a quick recovery if only prices and wages fell really sharply as in 1920-21. But at least he admitted that he got it wrong. Similarly, there is no special insight that Austrians offer in analyzing the mistakes of raising taxes, and wages in the middle of a deflation. That was the point of my “Hoover is an idiot” crack, you don’t need to deploy the cumbersome apparatus of Austrian business cycle theory to figure out the idiocy of the policies adopted by Hoover, any half-way intelligent undergraduate should be able to do that much. The Great Depression was a monumental catastrophe, and all the Austrian business cycle theory can explain is why RGDP stopped growing in the second half of 1929, if that.

  146. Gravatar of ssumner ssumner
    6. May 2009 at 05:56

    Thanks David, I find your analysis pretty persuasive.

  147. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 07:42

    Scott — I’m referring to Tyler’s own stated views.

    Here’s the “for instance”. Hayek’s 1929 discussion points to “enhanced expectations” and bubble like lending behavior as one of the potential causes of misallocation of resources across the time structure of production — with no “central bank” intervention required. Tyler Cowen’s talk of a bubble of money coming from China in the 2000s would be an example of this (John Taylor and others say the evidence is against Cowen on this).

    Now, the core of Hayek’s theory is misallocation of resources and distortion of the time structure of production (see Garrison to learn what this is). This is made possible by the existence of money and credit institutions (Hayek doesn’t think it can really get off the ground in a “barter” economy without money or credit). This misallocation and distortion can have several sources. The central bank is just one of them.

    But Tyler Cowen falsely says the “Austrian” theory is falsified by the identification of a source of misallocation other than the central bank.

    This is just bad economics, bad history of ideas — and irresponsible explication because it’s false. Unfortunately Cowen has never acknowledged that he has been putting out false information and attacking a theoretical construction on false grounds.

    The important point is that Hayek simply is pointing out that resources can be misallocated across time in unsustainable structural forms — and money and credit have the power to do this (see Garrison). The historical ways in which this happens can be different, and always are different in some particular ways.

    The easiest way to teach this misallocation process is to talk about central bank policy. But that isn’t functional core of the theory — as Cowen very falsely states and seems to falsely believe.

    Scott wrote:

    “Greg, Question–I am new to this. When you refer to “Tyler” do you mean his views, or the blog he links to.”

  148. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 07:47

    David, what you’ve written here is pure distraction.

    You haven’t read the Austrian literature by Garrison, Higgs, or the rest, it is clear.

    The only claim that Garrison, et al make is that Fed policy and a distorted time structure of production made a downturn inevitable — ABCT explains the onset of a downturn, it does not explain the catastrophe, which had other causes. Read it. It’s right there in Garrison in one of his articles on his web site.

    Again I have to ask, why the misleading distractions?

    David wrote:

    “attributing the severity of the Great Depression to misguided policies, like raising taxes and wages after the crash, may be perfectly valid, but it has precisely nothing to do with the Austrian theory of business cycles.”

  149. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 07:52

    David — this is more reasonable — and closer to the truth.

    You think the Lew Rockwell folks are crazy. Fine.

    Why drag Higgs, Garrison, White, Selgin, Horwitz and Hayek into it?

    David wrote:

    “Any Austrian who is honest (if you want I can provide a partial list of those excluded by that condition, but basically it includes every Austrian who invokes the writings of Hayek, Haberler, Machlup and Robbins in the 1930s that advocated deflation as a cure for the depression even though each of them subsequently repudiated that advice) will admit that the Austrian theory of business cycles has nothing (underscore nothing) to say about the behavior of NGDP after the upper turning point. Hayek recognized, even in his early work, the possibility of a “secondary deflation” that is triggered by the initial downturn, but that is an add-on to the theory, not the theory itself. And on his first try, Hayek unfortunately got it wrong, terribly wrong, in buying into the idea that you could have a quick recovery if only prices and wages fell really sharply as in 1920-21. But at least he admitted that he got it wrong. Similarly, there is no special insight that Austrians offer in analyzing the mistakes of raising taxes, and wages in the middle of a deflation. That was the point of my “Hoover is an idiot” crack, you don’t need to deploy the cumbersome apparatus of Austrian business cycle theory to figure out the idiocy of the policies adopted by Hoover, any half-way intelligent undergraduate should be able to do that much. The Great Depression was a monumental catastrophe, and all the Austrian business cycle theory can explain is why RGDP stopped growing in the second half of 1929, if that.”

  150. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 08:11

    Scott — the misallocation machinery tells us why up and downs are inevitable, and how money and credit can distort the economy and put it into disequilibrium. The aim of this use of micro is to explain why unsustainable booms and inevitable busts exist.

    The misallocation machinary doesn’t exclude all sorts of other things possibly happening or taking place after the economy goes into bust. Other uses of micro will explain that stuff — but these explanations while be shallow or mistake if they do not take into consideration the time structure of production and its relation to consumption. Which is exactly the criticism of the “Austrians” of what the Keynesians and Friedman / Lucas folks do.

    Roger Garrison has an article explaining how the ABCT theory explains the necessary ending of a misallocation boom, creating an inevitable bust — but it doesn’t necessarily explain the “depth” of the bust if other things come into play, like a Hoover or an FDR or a “real bills” doctrine following Fed.

    Scott writes:

    “So what is my point? It is that your Hoover is an idiot comment may understate the problem of Austrian Depression analysis. Yes, they have very good analysis of a variety of Hoover and FDR policies that hurt the economy’s supply side, and perhaps were ahead of some others in that area. But I don’t know whether they have added much to the question of how NGDP fell more than 50%. All those Hoover policies tell us why the 50% resulted in more RGDP losses than needed, but not why NGDP itself fell. So my question is this. Do they have an analysis of why NGDP fell sharply that is analogous to what is in your 1988 book, or my various published papers? Or is it comparable to F&S? Or to Temin? I honestly don’t know the answer. Greg tells me the Austrians agree that the money growth of the 1920s cannot fully explain the Great Depression. I have argued there are two Great Depressions, a nominal one (explained by gold standard defects we both agree) and a real one which was partly standard sticky wage/price AS/AD, and partly “idiotic” Hoover and FDR policies. We all know about the idiotic policies by now, but where are the Austrians in terms of the fall in NGDP? Anyone else can also answer my question.”

  151. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 08:21

    Steve Horwitz has a discussion of this in his book “Microfoundations and Macroeconomics”. Horwitz provides a “Austrian” version of the deflation work of Leland Yeager to explain this.

    Note again. “Austrian” economics is simply good microeconomic applied to macroeconomic problems, and taking into consideration the fact of heterogenous, time-taking production processes.

    I.e. “Austrian” macro is simply economics that takes seriously the fact that a capitalist economy actually has heterogeneity within it, in production and in labor and in consumption, and this heterogeneity involved differences in time structure, e.g. lengths of production processes, time preference of savings and consumption.

    If you think “K” captures all you need to know about the macroeconomy, you probably will never understand “Austrian” economics.

    Scott wrote:

    “All those Hoover policies tell us why the 50% resulted in more RGDP losses than needed, but not why NGDP itself fell. So my question is this. Do they have an analysis of why NGDP fell sharply that is analogous to what is in your 1988 book, or my various published papers?”

  152. Gravatar of david glasner david glasner
    6. May 2009 at 11:07

    Greg, I’m sorry that we are getting into such difficulty communicating because, based on many passed interactions, I think that our views are not as far apart as our recent exchanges may inaccurately suggest. You are right that I haven’t spent a lot of time reading the recent research produced by Garrison, White, Selgin, and Horwitz. But I was not criticizing them, and I did even mention them or their work. You did. I did mention Hayek, but when I mention Hayek, it is almost always to praise him. The exception is that I do say that he gave very bad policy advice in the middle of the Great Depression. But Larry White has written a paper (which I did read) that shows quite clearly that Hayek would not have given that advice had he stuck to the policy norm of stabilizing nominal expenditure that he had himself advanced in Prices and Production. However, my view is that Hayek’s great contribution as an economist is not his work on Austrian business cycle theory, but the meta-theoretical contributions that he made which grew out of his (unsuccessful, I think) attempts to reformulate Austrian theory and ground it on more secure logical foundations. From a history of thought perspective, Austrian business cycle theory rates little more than a footnote. Only two of its practitioners made important contributions, Mises and Hayek, and those contributions left little mark on the profession, except insofar as they led to Hayek’s great metatheoretical advances.

    You say ““Austrian” macro is simply economics that takes seriously the fact that a capitalist economy actually has heterogeneity within it, in production and in labor and in consumption, and this heterogeneity involved differences in time structure, e.g. lengths of production processes, time preference of savings and consumption.”

    I have no quarrel with that characterization. But, until the work of Garrison et al. becomes more widely known and accepted, it remains an as yet unfulfilled promise. So in my unwritten history of thought, the chapter on business cycle theory still does not have a lot to say about the Austrian theory of business cycles, but I admit that the chapter might one day have to undergo revision. As a matter of technical economics, I am inclined to think that there is not a lot of mileage to be gained from an Austrian research strategy of such appropriately modest pretensions, because in my view of the world, at least 90 percent of what happened in the Great Depression was the result of purely monetary forces, and more or less the same is true of the current cyclical episode. But that doesn’t mean that such a research strategy is futile or uninteresting. And if Garrison, White, Selgin, Horvitz et al. succeed in obtaining more powerful results than I think likely, I will not be upset in the least.

    So I thought that it was clear that when I rail against the Austrians, it is against the cult-like, fanatical movement founded and led by Murray Rothbard (and his acolytes) that has more or less coopted the idea of Austrian Business Cycle Theory as a grand (quasi-conspiratorial) explanation of the history of capitalism over the past two or three centuries. They are a bunch of cranks and ideologues. Even Ludwig von Mises, who was an extremist and a little crazy himself, couldn’t stand Rothbard (his disciple and former student), and refused to speak to him for the last 15 years or so of his (Mises’s) life.

  153. Gravatar of david glasner david glasner
    6. May 2009 at 11:22

    Greg, The problem with an ABCT explanation of the end of a misallocation boom is that the boom does not end until there is a monetary contraction. The monetary contraction under the gold standard was an increase in the central bank’s lending rate to prevent an external drain on its gold reserves. In a fiat currency standard, the monetary contraction is produced by the choice of the central bank to tighten because the inflation rate is perceived as too high or because of some other concern that gets the central bank worked up enough to choose to contract. The misallocation boom that arises under a fiat standard and a stable price level, does not have to produce a monetary contraction unless the central bank chooses to impose it. The kind sectoral adjustment that results from whatever modest stimulus to longer-term investment (or to other sectors favored by the injection of sufficient cash to prevent a falling price level) cannot plausibly be viewed as sufficiently distorting to be unsustainable, much less to produce a bust, in the absence of a deliberate monetary contraction. But perhaps I will gain further enlightenment further when I read Roger’s paper.

    Greg writes:

    Roger Garrison has an article explaining how the ABCT theory explains the necessary ending of a misallocation boom, creating an inevitable bust — but it doesn’t necessarily explain the “depth” of the bust if other things come into play, like a Hoover or an FDR or a “real bills” doctrine following Fed.

  154. Gravatar of Vasile Vasile
    6. May 2009 at 11:30

    “And on his first try, Hayek unfortunately got it wrong, terribly wrong, in buying into the idea that you could have a quick recovery if only prices and wages fell really sharply as in 1920-21.”

    David, since prices and wages didn’t fall sharply as in 1920-1921 how can you know that Hayek was wrong on that account?

  155. Gravatar of Vasile Vasile
    6. May 2009 at 11:38

    “The problem with an ABCT explanation of the end of a misallocation boom is that the boom does not end until there is a monetary contraction.”

    Well, yes. Obviously, this happens because the monetary authorities do not think that the further monetary expansion is sustainable. How is this to supposed to prove anything?

  156. Gravatar of david glasner david glasner
    6. May 2009 at 11:51

    Vasile, The 1920-21 depression was caused by the Fed to partially undo the enormous inflation of World War I. So you had a pure monetary deflation for a year or a year and a half and then the Fed called a unilateral cease fire and the depression ended. The only lesson to be learned from that is that the way to stop a depression is to stop deflating. The fact that there was less interference with price adjustment in 1920-21 made the reduction in output and employment less drastic relative to the decline in nominal income than it was in 1929-33. It doesn’t mean that the appropriate way to stop a depression caused by a deflation is to cheer on the deflation and keep asking for more. Talk about masochism.

  157. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 12:02

    David: “Greg, I’m sorry that we are getting into such difficulty communicating because, based on many passed interactions, I think that our views are not as far apart as our recent exchanges may inaccurately suggest.”

    I’d guess that a long conversation would reveal were often on the same page.

    David: “You are right that I haven’t spent a lot of time reading the recent research produced by Garrison, White, Selgin, and Horwitz.”

    On the Great Depression and the “WWII recovery” the work of Robert Higgs is the one that who’s really changed the conversation.

    “But I was not criticizing them, and I did even mention them or their work. You did.”

    Right. Because you were claiming to characterize the work of “Austrian macroeconomists”. These guys are the leading Austrian money, banking, and trade cycle guys. So I naturally assumed you were referring to them.

    David: “I did mention Hayek, but when I mention Hayek, it is almost always to praise him. The exception is that I do say that he gave very bad policy advice in the middle of the Great Depression.”

    Well, from a biographical / history of thought perspective what we might want to explain is why Hayek gave such bad advice (which no one followed), despite the fact that he already understood the “sticky wages” problem (identified in the 19th century by Marshall), and he already knew about the secondary deflation problem.

    I’ve offered my explanations — Hayek was very ignorant of the fact on the ground in America, Hayek had his eye on the British problem which began in 1925, Hayek spent almost no time looking at the empirical data — he spent massive hours on writing & teaching & editing with almost zero time devoted to looking at data, etc., etc.

    Why are people obsessed with an empirical bad call by a guy who spent no time looking at the data — and whose call had zero effects on policy in the real world. I’d say there is a bash Hayek agenda at work here, and nothing more.

    David: “But Larry White has written a paper (which I did read) that shows quite clearly that Hayek would not have given that advice had he stuck to the policy norm of stabilizing nominal expenditure that he had himself advanced in Prices and Production.”

    This raises biographical history questions, doesn’t it — not theoretical issues.

    David: “However, my view is that Hayek’s great contribution as an economist is not his work on Austrian business cycle theory, but the meta-theoretical contributions that he made which grew out of his (unsuccessful, I think) attempts to reformulate Austrian theory and ground it on more secure logical foundations.”

    Well, there isn’t a single thing called “Austrian theory”, and the distinction between theory and “meta-theory” simply begs the question about what good theory is and how it can be used to provide causal explanations — it would take a long conversation for us to get on the same page about the meaning of your expression “secure logical foundations”.

    “From a history of thought perspective, Austrian business cycle theory rates little more than a footnote.”

    Only if you don’t know the history. The IE construction gets started with Hayek’s cycle work. Hicks is explicit in saying that “growth” theory was provoked by Hayek’s work — inspiring Harrod to think about the problem. Hicks own equilibrium work was provoked by Hayek’s cycle work — Hicks is explicit about that also. This is core stuff in the history of economic thought.

    Hayek’s own work on “the knowledge problem” and the historic literature falls out of his cycle work as much as his socialism work — the changing valuation of production goods is a the core here for Hayek.

    David: “Only two of its practitioners made important contributions, Mises and Hayek, and those contributions left little mark on the profession, except insofar as they led to Hayek’s great metatheoretical advances.”

    I’m pretty unimpressed by who made important contributions and who didn’t. Economics is very complex and very hard and it takes a lot of good people learning a lot of stuff and doing all sort of different types of good work — economic science is a community project, and the more sound and productive people in the community the better.

    David: “You say ““Austrian” macro is simply economics that takes seriously the fact that a capitalist economy actually has heterogeneity within it, in production and in labor and in consumption, and this heterogeneity involved differences in time structure, e.g. lengths of production processes, time preference of savings and consumption.”

    I have no quarrel with that characterization. But, until the work of Garrison et al. becomes more widely known and accepted, it remains an as yet unfulfilled promise.”

    Catch-22, heh? This is a nonsense paradox.

    David: “So in my unwritten history of thought, the chapter on business cycle theory still does not have a lot to say about the Austrian theory of business cycles, but I admit that the chapter might one day have to undergo revision.”

    Everyone has the right to their own history …

    David: “As a matter of technical economics, I am inclined to think that there is not a lot of mileage to be gained from an Austrian research strategy of such appropriately modest pretensions, because in my view of the world, at least 90 percent of what happened in the Great Depression was the result of purely monetary forces, and more or less the same is true of the current cyclical episode.”

    The pebble that starts an avalanche is less than 1% of what happened — Garrison discusses these fundamentals of causal explanation in one of his papers ….

    David: “But that doesn’t mean that such a research strategy is futile or uninteresting. And if Garrison, White, Selgin, Horvitz et al. succeed in obtaining more powerful results than I think likely, I will not be upset in the least.

    So I thought that it was clear that when I rail against the Austrians, it is against the cult-like, fanatical movement founded and led by Murray Rothbard (and his acolytes) that has more or less coopted the idea of Austrian Business Cycle Theory as a grand (quasi-conspiratorial) explanation of the history of capitalism over the past two or three centuries. They are a bunch of cranks and ideologues. Even Ludwig von Mises, who was an extremist and a little crazy himself, couldn’t stand Rothbard (his disciple and former student), and refused to speak to him for the last 15 years or so of his (Mises’s) life.”

    Well. It wasn’t clear. Rothbard is dead.

  158. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 12:06

    Tom Woods is a historian who writes popular books.

    He’s not an economist. Most economists don’t write best sellers.

    David: “Tom Woods that is writing the best-sellers these days”

  159. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 12:09

    Is this an empirical claim or a theoretical point? It looks like an empirical claim, but I’m not sure is that’s what you intend.

    David writes:

    “The problem with an ABCT explanation of the end of a misallocation boom is that the boom does not end until there is a monetary contraction. The monetary contraction under the gold standard was an increase in the central bank’s lending rate to prevent an external drain on its gold reserves. In a fiat currency standard, the monetary contraction is produced by the choice of the central bank to tighten because the inflation rate is perceived as too high or because of some other concern that gets the central bank worked up enough to choose to contract. The misallocation boom that arises under a fiat standard and a stable price level, does not have to produce a monetary contraction unless the central bank chooses to impose it. The kind sectoral adjustment that results from whatever modest stimulus to longer-term investment (or to other sectors favored by the injection of sufficient cash to prevent a falling price level) cannot plausibly be viewed as sufficiently distorting to be unsustainable, much less to produce a bust, in the absence of a deliberate monetary contraction. But perhaps I will gain further enlightenment further when I read Roger’s paper.”

  160. Gravatar of david glasner david glasner
    6. May 2009 at 12:10

    Vasile, on your second point. There is a difference between a policy choice and an inherently unsustainable situation. Why is it obvious that if the monetary authorities choose to contract they are doing so because the pre-existing situation has become unsustainable? What would lead you or anyone to conclude in 1929 that a price level declining at about one percent a year was unsustainable? To infer from the stock market collapse between 1929 and 1933 induced by the Fed’s own monetary contraction in an environment in which very powerful deflationary pressures were being kept at bay largely by monetary expansion by the Fed that the stock market boom was an unsustainable bubble is entirely circular. There was no stock market bubble and as Scott shows in his account of the Great Depression, the market kept rallying after the 1929 crash in hopes that the Fed would stop contracting only to be repeatedly disappointed by the Fed’s intransigence or incompetence compounded by Hoover’s idiocy.

    Maybe we need to stop treating the word “unsustainable” as an undefined term. Would you care to offer a definition?

  161. Gravatar of Vasile Vasile
    6. May 2009 at 12:14

    “The 1920-21 depression was caused by the Fed to partially undo the enormous inflation of World War I”.

    But that’s pretty much what happened in the Roaring 20ties. Inflation. A great increase in the money supply. Which was masked by: a) increases in productivity b) a stock bubble.

    “It doesn’t mean that the appropriate way to stop a depression caused by a deflation is to cheer on the deflation and keep asking for more.”

    Are you missing two definition of deflation here? Yes, for an economy to adapt to a reduction to the money supply the prices/wages must fall. Not very pleasant, but that’s it.

  162. Gravatar of Vasile Vasile
    6. May 2009 at 12:32

    “There is a difference between a policy choice and an inherently unsustainable situation.”

    David, I simply find it hard to believe that central banks will choose a “hard/tough money” policy without compelling reasons. That’s not even a word for it. So, it speaks unsustainability for me.

    “What would lead you or anyone to conclude in 1929 that a price level declining at about one percent a year was unsustainable?”

    David, I don’t exactly understand what are you driving at? Maybe, it was possible with another less “roaring 20ties”? The price will tell me nothing about the match between investments and savings and whether the economy is on sustainable path. Do you think only individuals and firms can overextend themselves?

    And much less the price level will tell me about currently expected profits. While a collapsed stock can tell me something about it.

  163. Gravatar of david glasner david glasner
    6. May 2009 at 12:38

    So you are saying that the Great Depression was started in 1929 because the monetary authorities wanted to produce a deflation like the one in 1920-21? I’ve never heard that one before.

    On your next point, I do deny that there was any reason for the money supply to be reduced (relative to the demand to hold) that would have required a corresponding adjustment in wages and prices. The price level and the money supply in 1929 were perfectly fine and sustainable.

  164. Gravatar of david glasner david glasner
    6. May 2009 at 12:41

    Vasile, if you are saying that central banks only err on the side of inflation but never on the side of deflation, I disagree. I understand why you think that central banks may be naturally more disposed to inflation than to deflation, but are you really sure that you fully understand the thought processes of central bankers?

  165. Gravatar of david glasner david glasner
    6. May 2009 at 12:43

    Greg, I am not ignoring you, but it’s time for me to take a work break.

  166. Gravatar of ssumner ssumner
    6. May 2009 at 16:37

    vasile, Those are good observations, but I have a suggestion for Austrians. If Austrians want to be able to communicate with other economists, use the same terminology. Most economists call “inflation” a rise in the general price of goods and services. There was no inflation in the 1920s. I understand that Austrians consider “inflation” to be a rise in the money supply, or some other definition–perhaps asset prices. But why not just say “monetary expansion,” otherwise we are talking at cross purposes. The U.S. money supply has been rising for 230 years, with just a few dips downward. It is clear it can rise forever if we want it to. It is also clear that the money supply can rise rapidly during a period of deflation, such as the last 8 months, so I think things just get confused if sometimes inflation means money supply growth, and sometimes it means price level increase. In fast growing economies like China there can be rapid money supply growth and deflation at the same time, and for an extended period of time.

    I think that David is right that, in a technical sense, prices could have continued falling slightly after 1929, just as in 1927-29. Of course there were all sorts of institutional problems (as I am sure David would agree) from a lack of international cooperation to incompetence of Fed officials, which led to a different outcome. In addition, the U.S. could have switched to fiat money in 1929, and there would have been no Great Depression. Of course we all know that fiat money was also badly mismanaged in the 1960s-1980s (and I would argue right now), but there is no way to overstate the importance of the Depression. In my view that policy mistake was worse than all other Fed errors in history, COMBINED. It directly led to WWII for instance. Before the Depression, the Nazi’s were a minor party in Germany.

    I am a product of the 1970s. The University of Chicago. All my instincts are hard money. But in 1929 and 2008 money got too hard, with very bad effects. The 1921 depression was pretty severe, it was just very short. As I said, one problem with 1929-33 was the length of the deflation. Another might have been Hoover’s high wage policy. And another might have been that the deflation was less anticipated than 1921, when workers may have understood that WWI wage levels were unsustainable. I don’t know how important those last two factors were, my hunch is both played a role in making 1929-33 especially bad. But as David pointed out, it would have been plenty bad even without the Hoover policies, but with 3 1/2 years of rapid deflation.

    Greg, Thanks for the info on Tyler’s views. Since I haven’t read his piece, I’ll just say that in my view the Chinese saving wasn’t a bubble of money, and it might not even have been a bubble of credit. I think there is a possibility (not certainty, but possibility) that we have only seen the tip of the iceburg of Asian savings. China alone has as many people as the entire Western world (North and South America, Europe, Australia) If they are smart and keep saving at Singapore levels (40% of GDP) as they get much richer–then the mother of all credit bubbles may still be ahead of us. In any case, I see Asian saving as causing low long term rates, but not necessarily inflation. That’s entirely up to the Fed and ECB.

    It seems like Austrians keep saying that you cannot address business cycles without taking into account the time structure of capital/misallocation, etc. Yes you can. It may not be wise, but you can develop perfectly plausible business cycle models based on wage and price stickiness. And there was some wage stickiness even in 1921. My business cycle model doesn’t even include capital or interest rates at all. Just NGDP, RGDP, money supply and demand, and sticky wages. Everything in this blog basically relies on those 4 variables. I make neoclassical economists seem like Austrians by comparisons. So what can I do with my pathetically inadequate model? Show that hoarding of base money causes deflation and falling NGDP, and sticky wages mean falling NGDP leads to falling RGDP. And if you want to add on a financial sector with nominal debt—then fine. Deflation causes lots of defaults on nominal debts. There, I’ve just explained the past 12 months without even using the variables (like interest rates, M1, M2, exchange rates, budget and trade deficits) that Keynesians and monetarists think are essential.

    Occam’s Razor.

  167. Gravatar of Bill Woolsey Bill Woolsey
    6. May 2009 at 17:14

    Occam’s Razor?

    You are no fun!

    Really, I like complete, more realistic accounts, better than simple short cuts.

    I grant that in the final analysis, the supply and demand for base money are key to the determination of nominal income, and lots of things could impact the demand for base money. And yes, it is various sorts of nominal stickiness (including nominal debt contracts) that cause decreases in nominal income to be so disruptive.

    Still, all of that interest rate and financial market business is going on.

    I, for one, am willing to believe that open market operations in T-bills might well result in an added demand for base money that just matches the added supply. Maybe.

  168. Gravatar of david glasner david glasner
    6. May 2009 at 18:04

    Greg, Back to business. I actually am familiar with Higgs’ piece on the Great Depression from Woods’s summary of his argument in Meltdown. Based on that summary, I am decidedly unimpressed. The characteristic of a depression is that workers who are willing to work at existing wages cannot find employment, and therefore there is persistent downward pressure on wages. World War II put a stop to that chronic problem not just by conscripting workers into the armed forces but by creating a huge demand for their services in war related employment. Employment in war related industries also created demand for non-war-related products which could not be met until after the war which was why there was no post-war depression. It is also an implicit value judgment on Higgs’s part that the privations associated with war-time restrictions on personal consumption and conscripted service in the armed forces was not welfare enhancing. The answer would depend on whether the alternative to which we are comparing the wartime economy was peace-time full employment or subjugation to the third reich. I have no doubt what Hayek would have thought about what the appropriate comparison was.

    My references to Austrian business cycle theory were often ambiguous, and I should have been more careful about allowing my annoyance with much of what passes for ABCT to be subject to misunderstanding. So let me summarize my view. On the narrow interpretation of Austrian Business Cycle Theory as a theory of the cause of the upper turning point in the cycle, I think there is a plausible case that Austrian theory provides some insight into the upper turning point for some cycles, particularly under the gold standard. It is less plausible as a theory for the upper turning point under a fiat currency, but it may still have some usefulness. The work of people like Roger Garrison along those lines is commendable, but I don’t think that it matters all that much what causes the upper turning point as how to prevent a downward spiral from taking hold after the upper turning point. And on that issue I don’t think that ABCT has a lot to offer that we don’t already know from less complicated models.

    On Hayek’s importance for the history of thought, I am the last person you need to lecture on Hayek’s importance, but if you are trying to link up the Harrod and Hicks models of economic growth, which are, after all based on a homogeneous capital good, to Austrian business cycle theory, you really have a lot of explaining to do after your earlier lecture on how Austrian business cycle theory is all about heterogeneous capital goods. If I could give you a definitive refutation of the Austrian theory of capital and of business cycles, Hayek’s metatheory would still be valid. So even though Hayek reached that metatheory by way of a particular path of theory development, he wound up with insights that transcended the theory he started with.

    You want to know why I get so worked up about Rothbard even though he’s dead. Well, I might ask the same question of someone who has a whole website devoted to Taking Hayek Seriously. I find Rothbard and his intellectual progeny seriously annoying.

  169. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 18:39

    David, we should perhaps bring this discussion to a close, at least for now, in Scott’s forum.

    I must say one thing. Hicks make the direct link to Hayek, in both his own case, and in Harrod’s case, directly from what Harrod told him. Hayek and his macro work was the main influence — Hicks directly says so. Hicks says so more than once, in more than one place, over a number of different years.

    Your argument is with Hicks.

    David wrote:

    “if you are trying to link up the Harrod and Hicks models of economic growth, which are, after all based on a homogeneous capital good, to Austrian business cycle theory,\”

  170. Gravatar of Greg Ransom Greg Ransom
    6. May 2009 at 18:41

    David — If you’d like to write a review of the Tom Woods book, I’d be happy to post in on “Taking Hayek Seriously”. It might get some traffic, you never know.

  171. Gravatar of TGGP TGGP
    6. May 2009 at 18:53

    david glasner, you’re right that Higgs’ take on the welfare reduction of rationing & war-related resource diversion ultimately comes down to opinion (or at least we can say that measuring “real consumption” in tricky). A point I’d like to ask about is the expected post-war downturn that didn’t happen. It sticks in my mind because elsewhere someone asserted there was such a recession as after all major wars but in that case it didn’t happen despite the predictions of Keynesian economists. Do you think war-spending boosts the economy when it’s at the bottom of a recession but ending such spending doesn’t hurt once you’re out? Like the 1920 recession that did happen, the 1945 recession that didn’t is like an ever-present itch to me I want to hear explained, even if it doesn’t constitute a knock-down argument for anything.

    On devoting yourself to explicating one thinker: I think Feynman & melendwyr make good points, but on the other hand blazing your own trail is a lot more likely to lead to metaphorical wilderness than the tried and true path.

  172. Gravatar of Jon Jon
    6. May 2009 at 19:06

    Any Austrian who is honest …[snip slander]… will admit that the Austrian theory of business cycles has nothing (underscore nothing) to say about the behavior of NGDP after the upper turning point. Hayek recognized, even in his early work, the possibility of a “secondary deflation” that is triggered by the initial downturn, but that is an add-on to the theory, not the theory itself.

    Yes this is right, but it misses the subtle argument. The broader policy position is

    1) “secondary deflation” is painful
    2) deflation to reestablish the price-level can cause the secondary deflation.
    3) if too much inflation occurs, reestablishing the price-level requires subsequent deflation
    4) the allocation of capital that arises from depressing the money-rate of interest below the natural-rate causes inflation

    Ergo, to avoid #1, its good to avoid #4.

    A critical element here is #2. Under a commodity or gold standard this is necessary unless you’re willing to gradually move the exchange-rate peg or are very patient.

    Under modern thinking where past inflation is paid in, the story is different. Hayek and Mises deserve a bit of respect that comes from an awareness of their ‘assumptions’.

    The Austrian capital structure theory has value regardless.

  173. Gravatar of ssumner ssumner
    7. May 2009 at 04:10

    Bill, First let me say that your responses that look in a detailed way at all the sectors of the economy often address commenter questions much better than my more abstract approach, which glosses over a lot of financial market issues. Nevertheless, a couple points:

    This is the only recession in my lifetime (with the possible exception of 1991) when nominal debt rigidity even seemed to play an important role. And as you know, even in this recession I think its actual role is less than it seems. Now if we go back to 1930-33, then you are certainly correct–nominal debt rigidities played a major role in banking crises, and hence the increased demand for gold (the medium of account at that time.)

    2. Swapping base money for zero rate T-bills may have little effect, especially if the Fed announces the increase is temporary (as they have done.) But that is actually also true of long term T-bonds, at least to some extent. Of course that is consistent with my “supply and demand for base money mechanism” and it simply means that the Fed ought to choose a monetary regime that is effective (and of course many have been discussed here.) Even under the current messed up regime, the “demand for base money” approach leads to insights such as that interest on reserves is a bad idea during deflation, and a penalty on reserves should be considered. Also QE. These are some of the most fruitful ideas for the current crisis, and they all come straight
    out of a “demand for base money” perspective.

    Greg, why stop now, we’re almost to 200 comments!

    David, I’d like to see you do that book review Greg offered to publish–your comments here show serious book reviewing talent.

    TGGP (and this relates slightly to Jon’s point too) The lack of a post-WWII depression is easy to explain in retrospect. After previous wars, the price level had to return to the pre-war level. For complex reason, the price level after WWII did not have to return to prewar levels. If you don’t need a post war deflation, you won’t get a post war depression (just the drop back to normal output as unemployment rose back up to the natural rate.) Here are a few reasons:

    1. In 1934 the price of gold was raised from $20.67 to $35/oz. This allowed the steady state price level to be 70% higher than before.

    2. The adjustment to that new and higher steady state price level did not occur in the late 1930s, because the zero interests rates of the Depression led to heavy hoarding of gold.

    3. The post war period saw a gradual return to higher interest rates, and thus a lower demand for gold.

    4. The Bretton Woods regime further lowered the demand for gold, as countries used U.S. dollars as reserves.

    5. It was illegal for U.S. citizens to hoard gold at that time.

    So we gradually went from less than 70% above the normal price level for $35 gold, to more than 70% above, when the system flamed out in 1968, and gold started rising above #35/oz.

  174. Gravatar of TGGP TGGP
    7. May 2009 at 08:58

    Thanks for the response, Scott. You’re good at gloss-light commentary when you put your mind to it.

  175. Gravatar of anon anon
    8. May 2009 at 01:49

    glasner,

    “Even Ludwig von Mises, who was an extremist and a little crazy himself, couldn’t stand Rothbard (his disciple and former student), and refused to speak to him for the last 15 years or so of his (Mises’s) life.”

    do you have references to back this up?

    cheers.

  176. Gravatar of ssumner ssumner
    8. May 2009 at 03:58

    TGGP, Thanks, now that school is out, I’ll try to “put my mind to it” more often. :)

  177. Gravatar of david glasner david glasner
    8. May 2009 at 06:02

    Anon, It was common knowledge back in the sixties that Mises, who was on board of directors of the John Birch Society (are you old enough to remember who they were?), was so incensed at Rothbard’s anti-Americanism and pro-Vietcong left-wing political agitation that he stopped talking or communicating with Rothbard. Unless the Rothbardians have engaged in major historical revisionism, this shouldn’t be too difficult to confirm. As for Mises’s extremism, his name appeared each month on the Birch magazine (American Opinion?), which you can probably still find in the collections of some libraries (perhaps even on-line.) And in Human Action, he wrote (sorry, don’t have the page reference, but you can probably look it up under “conscription” in the index) that, in the face of the Soviet threat, anyone who opposed military conscription was guilty of aiding and abetting the Soviets in their quest for world domination (or something along those lines).

  178. Gravatar of TGGP TGGP
    8. May 2009 at 17:43

    Robert Welch of the JBS was actually “kicked off the bus” by Buckley precisely because of his views on Vietnam. I’m currently sort-of in the process of reading Hilaire du Berrier’s “Background to Betrayal: The Tragedy of Vietnam”, published by an arm of the JBS.

  179. Gravatar of anon anon
    9. May 2009 at 03:30

    glasner,

    Thanks for the reply. I’m not familiar with the John Birch society, besides Reagan having a minor brush with them… and Mises was certainly ‘intransigent’ (as Jacques Rueff positively puts it), perhaps because he was trying to restore a 19th century classical liberal order which was long gone.

    The Rothbard-Mises thing is still quite surprising though – Rothbard never stopped fawning over his mentor even after his death (c.f. Rothbard’s obituary for Mises).

    I wonder if you could clarify your earlier claim that, “the history of business cycle theory still does not have a lot to say about the Austrian theory of business cycles”. I’ve only passing familiarity with the Austrian, Ricardo’s and Schumpeter’s theories on the business cycles. The basic gist, as I understand it – is that the business cycle happens when resources have been ‘misallocated’, which could be brought about by sudden ‘shocks’ in the economic environment, or market-signals distortion (which can, but not necessarily, be triggered by loose monetary policy). This idea appears credible to me, I’m curious if there are alternative views.

  180. Gravatar of anon anon
    9. May 2009 at 03:40

    glasner,

    Also it would be much appreciated if you could further elucidate your thoughts on the Austrian school – their theories, as well as their apriori (praxeological) approach. Just trying to get a broader perspective here… and by Austrian, I don’t mean Rothbard. The Rothdroids should just rename the Mises Institute to the Rothbard Institute.

  181. Gravatar of Devin Finbarr Devin Finbarr
    9. May 2009 at 13:45

    Now I suppose if banking is key to the business cycle, that gap in my knowledge would be a big problem. But I don’t think it is.

    Scott, you argue that that banking is not central to the problem of the business cycle, and then you give me four examples of recessions/depressions caused by banking. In three of the examples you site the Fed as the cause. But the Fed is the central bank, they impact monetary policy via pulling the levers of the banking sector.

    Also note that if you go back before the Fed, most of the major crashes and depressions in U.S. history originated in the banking sector. The U.S. has always had a rickety banking system that engages in maturity mismatching.

    The question you might ask yourself is, why is the entire thing so fragile? Why does the Fed feel the need to tighten? Why does a small amount of tightening seem to multiply, cascade, snowball into economic collapse?

    My focus is on what I do know, which is that monetary policy has almost unlimited ability to steer expected future NGDP growth.

    Banking matters because the mechanism of reinflation matters. If you reflate the wrong way ( for instance by reflating the credit bubble), you will end up creating more problems in the future.

    Moldbug and I made the claim that maturity mismatching is a cousin of the Ponzi scheme. The most stable equilibrium is after the Ponzi scheme has collapsed. Or in other words, the most stable equilibrium is when demand for actual dollars ( as opposed to Ponzi dollars ) is maximized. You want the Fed to reflate mainly via demand side mechanisms. This is akin to trying to rekindle the Ponzi scheme, it will result in further disequilibrium. I argue that the Fed should reflate via supply side, which will lead the system to a more stable long term position.

    One other question. You keep talking about crises and bailouts. I don’t recall many between 1934-1990. Am I right, and if there weren’t many banking crises, why not?

    Mainly because of the FDIC. When you have FDIC coverage, it’s functionally equivalent to running a 100% reserve system, and then having the government print money and give it to banks to lend out. This kind of system has its own drawbacks, but it is free from the risk of a bank run.

    Starting in the early 70′s, a Shadow Banking system started to grow up. It was small at first. But thanks to the “too big to fail policy” starting the 1980′s, it grew bigger. Worse, combining “too big to fail”, a lender of last resort, and deregulation basically gives Wall St. a license to take massive risks and engage in call kinds of shenanigans.

    So what can I do with my pathetically inadequate model? Show that hoarding of base money causes deflation and falling NGDP, and sticky wages mean falling NGDP leads to falling RGDP.

    Most economists agree that an increase in hoarding of money results in deflation. It follows from the axioms of supply and demand. The $64 trillion dollar question is why the economy is so prone to these shocks where demand for money increases rapidly in a very short period of time? What causes this sudden desire to hoard? How can it be avoided?

    Also, it’s not just the hoarding of base money that comprises the demand shock. It’s hoarding of all notes backed by the full faith and credit of USG.

  182. Gravatar of ssumner ssumner
    10. May 2009 at 05:40

    Devin, The Fed is not a “bank” in any ordinary sense of the term. We use the term “central bank” because the early central banks started out as commercial banks. Banking had nothing to do with lots of depressions (1921, 1930, 1938, 1982, etc.) I admit that a bank panic can increase demand for base money, but under FDIC that’s not a big problem. The current increase in base demand is of course due to the policy of paying interest on reserves.

    Why is the system so fragile? Because monetary policy is often inept–as in 1921, 1930, 1938, 1982. Banking doesn’t explain those crises. The general problem of NGDP fluctuations (as compared to the specific problem of things like too big to fail–which we agree on) can only be fixed through sound monetary policy. policy must be forward-looking. Rather than try to explain money demand shocks, the $64 dollar question is how to offset them with suitable changes in the base. That’s where the Fed needs to be aggressively forward-looking.

  183. Gravatar of david glasner david glasner
    10. May 2009 at 08:28

    Anon, On the John Birch Society you could check here for starters, though it’s just a curiosity and probably not worth the time and effort to find out about them any more. On Austrian Business Cycle theory, my view is that the basic theory that a low rate of interest brought about either through central bank policy or by the sluggishness of banks in adjusting their lending rates to an increase in the Wicksellian natural rate which then leads to a lengthening and deepening of the capital structure is one (of many) plausible explanations for business cycles. The most obvious problems with it are that bank lending to businesses has usually been short-term and mainly undertaken to finance inventories and working capital, not the long-term investment projects that the Austrians seem to have in mind. But readier financing for inventories may make it easier to raise funds for fixed capital as well. Second, the Austrian argument for cycles is based on a notion of “unsustainability” which is pretty ill-defined and elastic. Under a gold standard, where credit expansion in one country relative to others would result in an external drain, the basis for the unsustainability was pretty straightforward. But under a fiat currency, there is no such constraint and the unsustainability argument becomes very hard for me to buy into. In the context of the Great Depression, the US had 40 percent of the world’s monetary gold reserves in 1929, so there is no plausible explanation for why the US could not have continued the pre-1929 monetary policy indefinitely, so I do not accept that the Austrian explanation is relevant to that particular episode, but I do not assert that it could not be relevant to others. Obviously I also cannot accept the extravagant claims of many Austrian theorists that theirs is the only coherent explanation of business cycles.

    Just about every business cycle theory (other than modern real business cycle theory which views business cycles as an equilibrium phenomenon) requires that there be some kind of market distortion or disequilibrium that results in the need for an unanticipated real adjustment in resource allocation. For a variety of possible reasons the readjustment in resource allocation requires a temporary reduction in output which can under some conditions become cumulative which is what characterizes a recession. The Austrian theory focuses on one type of real readjustment, but not on the potential for a cumulative reduction in output as result. Keynesian analysis is one way to try to understand how the cumulative reduction in output is initiated by an output reduction, but there are other ways to do that analysis that are more in line with the Austrian tradition, though Mises and especially Rothbard seem averse to considering the implications of any cumulative process.

    On Austrian methodology, praxeology and apriorism were Mises’s philosophical inventions. Other than Rothbard and his followers, I think that most Austrians did not buy into that philosophical position. Hayek did not accept it for the most part, following Popper instead (see his dedication to Studies in Philosophy Politics and Economics). Haberler also was an early proponent of Popperianism. In general, I think that many recent Austrian economists, Israel Kirzner especially, have made important contributions, but I do not really understand why Austrians continue to find it important to identify themselves so self-consciously as Austrian economists.

  184. Gravatar of david glasner david glasner
    10. May 2009 at 08:30

    Anon, I meant to provide you the link to the Wikipedia entry on the John Birch Society but I guess I did something wrong.

  185. Gravatar of Devin Finbarr Devin Finbarr
    10. May 2009 at 18:58

    Scott-

    The Fed is not a traditional bank, but it is intimately connected with the banking system. Every action it takes to expand or tighten is done by controlling the ability of banks to lend.

    Or more precisely, the Fed gets to control the rate at which banks can maturity mismatch. In a system of maturity matching, there would be no such thing as “base money”, “reserves”, etc. There would just be money. Under a maturity matched system, if the Fed wanted to tighten, it would have to actually go out and confiscate dollar bills and burn them. Claiming that maturity transformation did not cause depressions because “the Fed” caused the crisis is absurd, because the Fed’s entire roll in the economy is regulating a system of maturity mismatching.

    Earlier, Moldbug and I likened maturity mismatching to a Ponzi scheme. The Fed can be seen as an institution that keeps the scheme propped up. However, the presence of the Fed essentially gives banks a license to print money. Sometimes the banks are printing too much, and the Fed is forced to tighten, and we get a recession. Sometimes, this tighten causes the whole Ponzi scheme to collapse and we get a depression. Or sometimes the Ponzi scheme collapses on its own, such as in the current downturn.

    I admit that a bank panic can increase demand for base money, but under FDIC that’s not a big problem.

    Right, but these shadow banking systems (the SIV’s, money market funds, CDO’s, etc.) was not FDIC covered, hence the problem. They are also not even part of the Federal Reserve System, hence the extraordinary extra measures and “facilities” the Fed has had to create in order to deal with the problem.

    The current increase in base demand is of course due to the policy of paying interest on reserves.

    First, the relevant demand shock we are witnessing is a demand for all paper backed by the full faith and credit of USG – Treasuries, reserves, CD’s, etc. Sovereign wealth funds replaced SIV’s and MBS’s with Treasuries. Money market funds have stopped buying CP and started buying short term Treasuries. The collapse of the maturity mismatching bubble led people to buy paper backed by the USG. This caused a massive drop in the price of the world’s wealth that was far greater than the fall in cash flows cash flows ( see: http://econlog.econlib.org/archives/2008/12/brad_delong_on_1.html ).

    I’m not a central banker, so I’m not an expert on paying the interest on reserves policy. But here is a blog post from an actual former central banker, and his take seems pretty reasonable. The point of the policy was simply to allow more fine-tuned interest rate targeting. The Fed increased the base dramatically and nearly instaneously to compensate for the increased demand for base ( see http://research.stlouisfed.org/fred2/series/AMBNS ) ( in fact, it has to increase the base in order to maintain its interest rates target). I don’t have any reason to believe that paying interest on reserves was a cause of tight money or the fall in NGDP.

    Rather than try to explain money demand shocks, the $64 dollar question is how to offset them with suitable changes in the base. That’s where the Fed needs to be aggressively forward-looking.

    The mechanics of an ideal reflation is easy. Take every bit of paper backed by the full faith and credit of the U.S. Then use the power of fiat to increase the face value of the paper by X%. For the current crisis, 20% would be a good start. Do more as necessary.

    It’s the politics of reflation that seems to be much more difficult.

  186. Gravatar of rtstewartmd rtstewartmd
    12. May 2009 at 03:44

    Don’t get confused with labels about Austrian or Keynesian or whatever in this question.

    Answer a VERY basic question with the most fundamental equation.

    GDP = v . M ; where v=velocity of money and where M=aggregate supply of money

    ‘M’ is mechanical in the US, it is controlled by banks and the Fed largely through the fractional reserve multiplier and the discount window (but not exclusively).

    ‘v’ is essentially psychological. Fear on the part of consumers and businesses forces them to NOT spend freely, thereby driving ‘v’ lower.

    Without a dissertation level mathematical proof, I think it is easy to understand that to focus solely on ‘M’ when we think about what caused the Great Depression and our current situation without focusing on what happens to ‘v’ is doomed to failure.

    It is the decline in ‘v’ which drove both declines in GDP, and it is not mechanical, but psychological. Mises discusses the importance of psychology in Human Action, and it is a critical issue in praxeology and catallactics, without which we will grope in the dark.

  187. Gravatar of qwerty qwerty
    13. May 2009 at 01:08

    The focus on V (velocity of circulation) in itself is a bit misleading – c.f. http://mises.org/story/2916

    Consumer spending as a proportion of GDP has actually increased – so Americans haven’t become more frugal. The decline in US consumption more accurately reflects a decline in incomes.

    It’s the banks who are not ‘spending’ – the problem is with all the bad debt sitting around, refusing to be liquidated.

  188. Gravatar of ssumner ssumner
    13. May 2009 at 06:35

    devin, The explanation the Fed gave for interest on reserves has been discussed endlessly here. Yes, they claimed it was so that they could control interest rates. As the world’s leading expert on bank interest on reserves (Hall) noted, that was a “confession of contractionary intent.” How can you argue it is not contractionary, when the Fed admits the intent was to keep interest rates higher than they would otherwise have been?

    I don’t agree that the Fed works through the banking system. The typical Fed action is to increase the monetary base by selling bonds to the public. The banks play no significant role in that process.

    There is a huge difference between base money and other Treasury debt–the nominal price of base money is fixed. That means the base in the medium of account. That means changes in the supply and demand for base money drive changes in the price level. This process would work equally well in an economy that didn’t have any banking system at all.

    rtstewartmd, I agree that both M and V fell sharply in the Depression, Indeed if you define “M” as I do (the base) then velocity was the entire cause of the contraction (in an accounting sense.) But in a policy sense M was the entire cause, because no matter how far V fell, the Fed could have and should have increased M just as much, even by going off the gold standard if necessary.

    querty, I agree that it is very misleading to focus on consumers saving more. Those are symptoms, to the extent they have occurred at all, which as you note is not clear.

  189. Gravatar of Greg Ransom Greg Ransom
    16. May 2009 at 13:39

    Note well that housing falls into Hayek’s category of long-term production goods — and so do cars.

    And how many structured investment vehicles were out there using short-term credit to buy long term assets? Ever heard of Whistlejacket Capital? Well, that’s the one that Orange County, CA has a $80 million dollar stake in.

    It’s delusional to believe that short term money didn’t get used to leverage long term capital goods — like houses, cars, businesses, office buildings, etc.

    David Glasner writes:

    “bank lending to businesses has usually been short-term and mainly undertaken to finance inventories and working capital, not the long-term investment projects that the Austrians seem to have in mind.”

  190. Gravatar of Mike S. Mike S.
    2. August 2009 at 18:52

    You mention that manufacturing did not see a boom during the housing boom, but how do you know it wouldn’t have declined were it not for the generalized credit bubble? Also, aggregate demand was around 70% consumption and there was no boom in manufacturing, then were there booms in other sectors, such as the service sector?

  191. Gravatar of Shining Raven Shining Raven
    1. October 2012 at 05:32

    Scott said:

    “The explanation the Fed gave for interest on reserves has been discussed endlessly here. Yes, they claimed it was so that they could control interest rates. As the world’s leading expert on bank interest on reserves (Hall) noted, that was a “confession of contractionary intent.” How can you argue it is not contractionary, when the Fed admits the intent was to keep interest rates higher than they would otherwise have been?”

    Which interest rates are you talking about? The interest on reserves is necessary to keep the Fed funds rate at a non-zero value. And of course the FFR has all kinds of effects on other interest rates. If the Fed stopped paying interest on reserves with the current level of excess reserves in the system, the FFR would immediately drop to zero.

    Now, you can argue that you believe that the Fed should set the FFR to zero, but then your argument would really be with the level of the FFR. But as long as the Fed conducts monetary policy through the FFR, it needs to be at a finite value, and there needs to be a floor from an interest rates on reserves.

    I know that this paper from Keister, Martin, and McAndrews from the NY Fed has been linked here before, but it really explains how the policy works:

    http://www.ny.frb.org/research/epr/08v14n2/0809keis.pdf

    I would highly recommend it to anybody who does not yet know how the Fed implements monetary policy after quantitative easing.

    Scott said:

    “I don’t agree that the Fed works through the banking system. The typical Fed action is to increase the monetary base by selling bonds to the public. The banks play no significant role in that process.”

    What? Are you serious? Do you know with whom the Fed conducts open market operations? Hint: It is not the non-bank public!

    The Fed sells and buys bonds *to the banks*, not to the public, to affect the level of reserves in the Fed system. So obviously it conducts monetary policy through the banks. With no banks in the picture, things would work in a completely different way. You simply cannot forget about banks to understand what the Fed does.

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