September 2014

Sun Mon Tue Wed Thu Fri Sat
  1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 27
28 29 30        
Blog powered by Typepad

« Using the Economic Way of Thinking to Ex Post Rationalize Your Errors | Main | 21st Century Economic Methodology »

TrackBack

TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d83451eb0069e201157038d134970c

Listed below are links to weblogs that reference Which Monetary Policy Rule Suffers from the Fatal Conceit?:

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

In a modern monetary system, to say that the demand to hold money increases is, by and large, to say that people are holding on to more bank-issued IOUs. That ought to be a signal for banks to increase their loans, that is, to increase the real amount of savings they intermediate, thereby increasing the nominal stock of bank-supplied money in a manner that precisely accommodates the growth in nomianl demand for the stuff at the existing price level.

Of course, a chorus of anti-fractional reserve types will insist that money holders "really" want to hold, not IOUs but bailment tickets. But no matter how often they say it, or how many thousands of pages they write, it's not true. Since about 1600, in England anyway, the common-law has understood that, unless coins were supplied to bankers in bags, a debtor-creditor relationship was being established, and claims against the banker generated by the transaction, whether notes or deposit balances, were simple IOUs.

The 100 percenters are of course free to reply (as de Soto, for instance, has done) that the common law judges screwed up. If so, then the free market "screwed up," for the one can hardly be distinguished from the other.

As for the Rothbardians' belief that letting P fall to accommodate an increased real demand for money is just as good as, indeed better than, increasing M, I'm tempted to repeat Frank Hahn's remark, itself directed, rather unfairly,towards monetarists (who after all favored monetary expansion to combat deflation-based unemployment), to wit: "I confess that I sometimes hope that they may come to learn by personal experience what [involuntarry unemployment] is all about."

Dr. Selgin or Horwitz,

Would you provide a good reference for the MV stabilization argument? (Also if possible, ones addressing Rothbard on the issue.)

Thanks.

You guys have got me mostly convinced.

However, I still don't feel qualified to judge what banks are solvent and what banks aren't. I still think that if free banking ever arose I would stick to gold coins myself. I could see the benefit of using notes to those better able to understand the annual reports of banks.

Eric,

The three best places are:

Selgin, *The Theory of Free Banking*
Selgin, *Less than Zero* (available at iea.org.uk)
Horwitz, *Microfoundations and Macroeconomics*

I also make the argument in briefer form here: http://myslu.stlawu.edu/~shorwitz/Papers/Monetary_JHET_1996.pdf

You can also find my Monetary Equilibrium lecture from last summer's AE seminar at FEE here: http://fee.org/audio/130/

George may also have a good paper or two in his Routledge collection from a few years ago, but that's at home at the moment.

This might help as well: http://divisionoflabour.com/archives/005679.php

And for specific responses to Rothbard(ians), you can check this out:

http://mises.org/journals/rae/pdf/RAE9_2_5.pdf

and my book 170-75 and 222-31.

Dear George, I have experienced in my childhood and early youth days in Eastern Europe much worse things than involuntary unemployment, including war.

From your statement I can only conclude that you believe that additional credit inflation in bust can avert unemployment. Just like Friedman believed that root cause of Great Depression was not crazy credit inflation 1921-1929, and specially 1926-29 (as Hayek and Mises and Robins and Rothbard believed) but insufficient credit inflation 1929-32. Good like with that. Just explain me how deliberate deflation by FED 1920-21 didn't produce Great Depression but short and sharp recession and than fast recovery.

As for the main theoretical issue, the problem is as follows. Money serves, among other things, as a means of insuring against uncertainty to the people. When you decide to save more facing prospects of recession and economic hard times you don't see that as "irrational hoarding" that withhold resources needed for investment that must be rectify by monetary policy. You simply see expression of your changed preferences, and completely rational behavior. But, when millions of people do the same, saving more cash and spending less, then suddenly it ceases to be a normal thing, i.e. set of millions of individual decisions that express individual preferences for cash and saving, and becomes a "problem" that should be rectified by banks or central bank. How that praxeological alchemy works, please explain me? How millions of rational decisions of the rational people, when averaged and aggregated turn out to be irrational hoarding asking for remedy? At this point, it seems to me that assumption that decreasing velocity of money indicates that economy is underperforming, what can be remedied by monetary policy is very basic error. No, if people are hoarding and saving more, that means people have preferences for economy to slow down further. You and Steve say,, I am going to induce you to spend more because I think economy must not slow down, because unemployment will rise still more. But, then, why not fight against any conceivable recession by creation of additional money supply? You are on the slippery sloap to Mankiw http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=2

He proposes to Bernanke to increase inflation tremendously, in order to tax "excessive cash holding" (those evil money-kulaks). Or to force negative interest rates to spur agregate demand (to fight "excessive involuntary unemployement" in your parlance). Choose your pick.

P.S. "God luck" ,instead of "Good like" in previous comment. :)

I think the criticism, particularly between economists who share the same values and similar concerns, is too harsh and should be nuanced.

First of all, asserting that any supply (or quantity) of money is optimal, as not only Rothbard but most classical economists did (Say or Mill, for instance) is essentially arguing that the numerical amount of the stock of money is irrelevant, because prices will adjust(especially in the long run or if it is done in a coordinated way). That means that it is equally good to introduce a gold standard (with scarcer currency) than a silver standard (more abundant) because with a gold standard, prices will simply be a fraction of those in a silver standard. This concept can also explain why the introduction of "new francs" in France in 1960 (100 old francs=1 new franc) provoked no distortions (and numerically it was a total collapse of the money supply, reducing it by a factor of 100!) Prices adjusted by being divided by 100 (Horrid deflation in keynesian terminology, but harmless, even practical, in the real world). Likewise, Venezuela introduced the 'strong' bolivar in 2008 (1,000 old bolivars=1 new). Prices also adjusted without trouble -hyperdeflation of 100,000% in a day. Many other historic and contemporary examples abound. However, it's not easy to explain this in keynesian models or in most monetarist 'anti-deflation' frameworks.

Now, almost all classical schools assert that he distortions and problems come with variations in the money (and credit) supply and especially through the assymetric channels of money creation and money transmission. Hayek and Mises were particularly brilliant in illustrating this -and this is the crucial element of Austrian cycle theory. This has monetary implications: If, let's say, silver's supply is more stable and less volatile than gold's, silver will be more suitable as a currency standard.

This brings me to a related issue that, respectfully, should nuance Mr. Horwitz and Mr. Selgin's positions: It is very difficult to discern whether the volatility of money demand has its origin in the volatility of the money supply. The typical case is a pre-devaluation scenario like that of Argentina 2000, USA 1930-33 or almost any banking crisis: The tremendous and destabilizing spikes in money demand (in the short term) were clearly related to concerns on devaluation risks (brought about by expansionary monetary policies inconsistent with a fixed exchange rate regime) and concerns on the solvency of banks (usually brought up by credit expansion).

Although I have many doubts on the question of fractional reserve vs. free banking, I believe Mr. Huerta de Soto has very good arguments in criticising fractional reserve banking. If it is unchecked by common law (just as theft is), bank credit will tend to be more volatile and banks insolvent by nature -thus needing a central bank to cover them in bank panics. But it is also a possibility that law is not needed and competition could discipline banks, as free bankers contend.

Nikolaj:

Why is it an "either/or"? Why can't it be the case, as I think both George and I believe, that credit inflation in the 1920s precipitated the bust and the Fed's failure to stem a massive monetary deflation from 30 to 33 made the bust that much worse than it would have been otherwise? Why can't both be true?

As for 20-21, one major reason that recession didn't turn into a Great Depression is that it lacked a number of the other features of the early 1930s that make that depression a "Great" one. I'm thinking here of Hoover and FDR's attempts to keep prices and wages artificially high, as well as a variety of other policies both pursued.

20-21 was indeed a sharp but short recession. Its depth was significant, however. Unemployment for 1921 averaged 11.7%, suggesting that some months were higher. Vedder and Gallaway suggest it could have been as high at 15%. That is not insignificant.

Prices did fall fairly rapidly, wages somewhat less so. But clearly neither fell rapidly enough to avoid maybe as much as a year's worth of double-digit unemployment. Even in the notably less hampered market of 1920-21, imperfect adjustments to too little money meant real economic harm.

As V&G also note, not only did the absolute money stock fall by 8 percent in 1921, there was also a sharp decrease in the velocity of money. That double whammy of M and V down explains the trouble, even if it was much shorter-lived than the GD. V&G blame the Fed for failing to respond to those changes in V.

If advocates of free banking are right that it would avoid even something like 20-21 and would cause no additional harm of significance in the process, why not do it? You keep referring to all increases in the money supply as "credit inflation." Again, that begs the question. The ME-FB argument is that some increases in the money supply are not inflationary, (i.e., those that match increases in MD), thus there's no problem in doing them.

1920-21 certainly shows that without governmental attempts to make prices and/or wages even stickier, recessions are generally short but sharp even when induced by too little money (rather than too much). But even such recessions can be avoided with proper monetary institutions.

The Great Depression was both "great" and a "depression" because of three factors:

1. The inflation of the 1920s
2. The deflation of 30-33
3. The various government interventions that prevented prices and wages from adjusting as well as they can, which still remains imperfect.

The 1920-21 episode does need more detailed investigation by Austrians, but nothing I've seen so far convinces me that it's inconsistent with the arguments I've been presenting.

Steve:

"My response was to deny that I know better than individuals how much money they "should" hold, and then argued that the point was that whatever quantity they wished to hold at the current price level, it should be supplied."

Why on the "current price level"? Why current price level must be kept whatever else happening in economic system? When people hold more cash it purchasing parity increases. I d

"We are not pretending to know how much money the public "should" hold, nor are we pretending to know how much we should supply."

Yes, you are pretending, because you say price level should be stable, and if public holds too much cash in order to cause price level to decline, "we" must infuse additional money to provide stable price level. Instead to respect people's preferences for more cash and less investment and spending, you think you can without cost to deceive them by inflation to invest and spend, although underlining economic conditions that caused their initial decision to invest and spend less, were not changed in the least.

Steve, theory that every quantity of money is optimal was not developed by Rothbard, but by Ricardo, and accepted by Mill, Say and many others. And 100% gold standard was also Mises's idea, not only Rothbard's. You are trying to discredit doctrines you reject by ascribing them only to Rothbard, to make them appear fringe, extremist stuff, because "you know those guys, anarchists, Talibans from Alabama, Rothbard and his sect, they advocate such strange theories as gold standard and every quantity of money is optimal".

So, you are fighting against much more diverse group of enemies, apart from Rothbardian sect from Alabama. And that group of people entrapped in fatal conceit of deflationism includes Mises, Say, Mill, Ricardo and many others.

Nikolaj,

1. I am NOT in favor of price stabilization. You have again misread me. I do think that the price level should move inversely with changes in productivity and that monetary policy should do nothing to offset that. Money-side changes to the price level are damaging, as every Austrian knows from the analysis of inflation. I'm just applying the same logic to deflation. It's the 100% reserve crowd who is inconsistent here.

2. Thank you for the history of economic thought. I'm well aware of who made the historical comments about the optimal quantity of money. I picked on Rothbard because we were having a discussion about contemporary Austrian views on these matters. I am not trying to "discredit doctrines by ascribing them to Rothbard." I'm trying to discredit them because they are wrong. Rothbard said a lot of very correct things and he said a lot of wrong stuff too. This was one of the latter.

BTW, if you're so knowledgeable about the history of economic thought, you would have tempered your comments about Mises and 100% reserve, as the early Mises did not support it so clearly and was much closer to the monetary equilibrium position on inflation and deflation that I've been arguing for here. I'm not worried that I'm somehow in major disagreement with Mises (...not that there's anything wrong with that...).

You know it's funny how you have started to question my motives and good faith here. I'm engaged in a difference of opinions over monetary theory and institutions. I'm not out to discredit anyone or fight against any "enemies" real or perceived. I just want the best monetary theory and institutions possible.

Why are you so quick to assume I'm engaged in some kind of attempt to tear people down and why are you putting words in my mouth about my views about other people?

Nikolaj, you seem to assume that, because I believe that no good comes from allowing MV to shrink, therefore I'm oblivious to the dangers from having it expand. Nonsense. Mine is the consistent argument that, if MV is allowed to expand too fast, as was the case in the mid to late 20s, that's bad; and if its allowed to shrink, as in the early 30s, that's bad too. Your argument, on the other hand, is both inconsistent and implausible. You think aggregate demand innovations are only non-neutral in one direction, and upwards no less.

As a general point, you are too much inclined to criticise people, not for what they actually claim, but for arguments you impute to them without good reason.

P.S. Its "Fed," not FED.

There's no such thing as P, or V... There are lower order goods and higher order goods (from the individual's perspective), and their prices...

ABCT's bust is about adjusting relative prices, not some inexistent price level... Additions to the money supply via FRB will only keep the relative prices distorted, i.e, higher order goods prices up relative to lower order goods, in a scenario where people desire to change the relation...

Rafael Hotz: "Additions to the money supply via FRB will only keep the relative prices distorted"

But, is that true. Or, to be more specific is it true that no extra money causes less distortion of those prices?

If you think about it you don't need the quantity equation to explain what George Selgin and Steve Horowitz are saying.

This is how it works on the individual level.... There is a recession. Things become more uncertain and the demand to hold money increases in some parts of the population. Monetarists would call that a decrease in V, there is no need to though. Banks then satisfy that increased desire by issuing more money substitutes. They make funds to do this by changing their actions elsewhere. (They can't just print money or they would become insolvent).

This causes relative price changes. But there would also be relative price changes if banks could not do it.

Steve & George,

Is this right:

Upon the onset of a recession, in addition to economic restructuring, the demand to hold money increases. A bust exposes the mistakes of a boom, but because so many expectations are shattered (i.e. knowledge is scarcer), it scares even those who did not malinvest. Accordingly, the perceived risk of almost all investments increases, so the market is saturated sellers in search of something less risky, and the demand for money increases.

While money is rapidly soaked up by frightened investors, prices in the rest of the economy do not adjust instantly, especially wages, and, in consequence, unemployment soars and quality of life declines. However, the inevitable economic and political turmoil can be eased by credit expansion. The purpose is not to re-inflate the boom, but calibrate credit availability to the demand to hold money.

In a free banking system, interest rates would be more closely tied to savings rates, and an increase in demand for money would decrease the cost of borrowing. In other words, credit expansion would occur "naturally" to offset the drop in MV, and the economy would be spared much of the economic and political turmoil. However, since we are for the moment stuck with a central bank, it should attempt to emulate this.

Is that your argument?

I think that's pretty close Lee. My major quibble is with the assumption that the demand for money necessarily rises at the start of the bust. Maybe, maybe not. If it *does*, then your explanation largely follows.

The one thing I'd add is that in a free banking system, if the additional money holdings are via bank liabilities (notes, deposits, but not gold), then those holders are supplying the very savings that finance the additional issuances of credit that comprise the expansion of the money supply.

"My major quibble is with the assumption that the demand for money necessarily rises at the start of the bust." - Steve

I think it's an assumption that would hold better when the bust is bigger, since the more people who have their expectations shattered, the greater is the increase in perceived risks, and the more attractive money becomes as an alternative.

"The one thing I'd add is that in a free banking system, if the additional money holdings are via bank liabilities (notes, deposits, but not gold), then those holders are supplying the very savings that finance the additional issuances of credit that comprise the expansion of the money supply." - Steve

Yes, that's exactly what I was trying to say in the last paragraph.

In class, we were taught that credit expansion created inflation (defined as a rise in prices as measured by the CPI). At the time, it occurred to me that no such inflation would occur if falling interest rates were matched by rising savings, because every extra dollar spent by borrowers would be offset by a dollar saved by investors. Although their would be price adjustments in the economy, as prices fell for consumables and rose for capital, the average price would remain steady (of course, whether the CPI would capture this is another matter).

But I am still sceptical as to how well a free banking system would calibrate the interest rate to savings. It seems to me that even without the Federal Reserve, fractional reserve banks would still issue too much credit.

By the way, thank you for responding. I am greatly enjoying this topic of discussion, because many of these issues have been bugging me for a long time.

"Money-side changes to the price level are damaging, as every Austrian knows from the analysis of inflation. I'm just applying the same logic to deflation. It's the 100% reserve crowd who is inconsistent here."

So, if supply of gold in 100% gold standard increases in one year more than production of goods, that "inflation' should be somehow "damaging".

"I am NOT in favor of price stabilization. You have again misread me. I do think that the price level should move inversely with changes in productivity and that monetary policy should do nothing to offset that."

Except in recession, and not in all, but only in "secondary" recessions with "particularly painful downward adjustments".

As for Mises his adherence to 100% godl standard is clear. In Theory of money and credit (1912) he says:

"...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."

In many other occasions Mises repeated his rejection of fiduciary media and fractional reserve banking, as well as support for 100% gold standard. i didn't mean to criticize you for disagreeing with Mises, but on the contrary, for trying always to look like you are in agreement with him even when you are not (for example, on this particular subject).

Further, if I correctly understood your point, you think 1920-21 non-reaction to deflation was mistake that worsened the recession?

I think key to resolving the confusion on this matter is to understand the difference between inflation and inflation:

Money-inflation: an increase in the money supply.
Price-inflation: an increase in the price-average.

Money-inflation need not result in price-inflation. If the savings rate increases, then banks can expand credit. The price-deflation caused by the higher rate of savings is then offset by the money-inflation created by expanded credit. Therefore, the price-average remains steady, even though the money supply has increased.

Since such a money-inflation is caused by credit expansion, when the borrowers start paying off their debt, the savers will start spending again, and, presuming the borrowed resources were well-invested, a moderate and good deflation will occur--reflecting the overall increase in productivity.

"Mine is the consistent argument that, if MV is allowed to expand too fast, as was the case in the mid to late 20s, that's bad; and if its allowed to shrink, as in the early 30s, that's bad too."

And it was bad also 1920-21?

"As a general point, you are too much inclined to criticise people, not for what they actually claim, but for arguments you impute to them without good reason."

No, George, I am just waiting to see the answer on obvious question: how millions of perfectly rational individual decisions to save more and spend less as an insurance from uncertainty in hard times, translates by some mystical macroeconomic transubstantiation into the "problem" of "irrational hoarding" that needs to be remedied by banks or governments? And in what regard your principles are different than say Mankiw's?

In a recession instead of saving more and spending less people could go to the pawnbrokers. What is a few million people did this and pawned some of their belongings. They would then not need to spend much less immediately.

Similarly, what if those people go to the bank and get bank-loans instead of spending less or pawning? As long as those bank-loans are solid there is nothing wrong with that. The bank may issue new banknotes to them and increase the money supply. That is fine so long as the banknotes are explicitly debts.

To prohibit this from happening during "secondary recessions" or any other time is applying a special rule.

Nikolaj,

I don't think anybody here has suggested that increase in the demand for money is "irrational hoarding". In fact, it is a quite sensible reaction to an increase in the perceived risk of alternatives. However, money held in a bank account is a form of savings that banks can tap into and expand credit issuance.

Moreover, the bank customer, the one holding the money, still enjoys less risk, because the risk and costs of further malinvestment will be more widely spread.

Though George or Steve might correct me on this.

Lee writes:

"But I am still sceptical as to how well a free banking system would calibrate the interest rate to savings. It seems to me that even without the Federal Reserve, fractional reserve banks would still issue too much credit."

This is a good question Lee. I think the answer lies in understanding the relationship between the demand for bank liabilities and savings. I can't do it all here, but when people hold bank liabilities, they are providing loanable funds (savings) to the banking system by not spending their bank balances or their notes, which gives the bank the ability to, in turn, create more loans (investment) off the given supply of reserves. Selgin's book and some follow up papers explain this in detail.

To the extent that free banks produce the quantity of liabilities the public wishes to hold they are simultaneously providing the quantity of funds for investment that matches the public's willingness to save through the banking system. And if they are doing that, then the market and natural rates will be equal.

This also explains why if the demand for money rises and free banks respond by supplying more (where money = bank liabilities), it doesn't trigger the usual Austrian story about inflation and the cycle. The public saves more by holding bank liabilities and free banks turn that into investment by lending more off their given reserves, which they can do precisely because the public is claiming fewer of those reserves by holding more of their liabilities.

And this is exactly why, as you say in your last comment, this is NOT "irrational hoarding." People wanting to hold more money is not irrational. A banking system that didn't produce more liabilities in response would be a poor one as it would be allowing the natural rate to rise above the market rate and ex ante savings to exceed ex ante investment, the result of which would be the deflationary recession described by Wicksell and other monetary disequilibrium theorists of the 20th century. That is what free banking tries to avoid.

This is why I need to get my book republished or out in paperback as all of this is in there, but no one's paying the ridiculous price Routledge is charging for it.

Nicolaj:

Do you believe that government intervention can distort incentives/information in ways that lead generally self-regarding individuals to make choices that add up to negative consequences for society? I do. Think about tragedies of the commons for example.

The argument here is the same. Under poor monetary institutions, the decision by many people to want to hold more money, though individually rational, leads to negative consequences because those institutional arrangements are unable to respond appropriately to that increased demand. Under free banking, we've argued, this problem goes away.

The other key to the puzzle is to recognize that even in an unhampered market, prices don't instantaneously and perfectly react to changes in demand and supply. There is a discovery process that involves lags/stickiness. If you grant that, then the decision by many market actors to hold more money by reducing expenditures can lead to a period of economy-wide excess supplies as prices and wages don't immediately and perfectly fall. Nothing mystical there, just the imperfect market discovery process that Austrians have talked about since Menger.

Now you might believe that those imperfections are quickly remedied and you might believe that there are costs associated with adjusting the nominal money supply in respond to changes in money demand, so that you might argue, empirically, it's better to let prices fall than to adjust the nominal money supply. That's not an unreasonable position. It's not necessarily a priori wrong, but I do think it's empirically-historically mistaken.

Nikolaj:

I see it's time to play "dueling Mises quotes." So here you go:

TTOMAC (312, 1938 edition):

"Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous other is not in a position to enter upon an independent discount policy. If regard to the behaviour of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then - apart from an extension of its clientele - it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange-value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause [i.e., not understanding that it requires competition to work]."

Or try his definitions of inflation and deflation (240):

"In theoretical investigation there is only one meaning that can 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. Again, Deflation...signifies: a diminution in the quantity of money (in the broader sense) which is not offset by a corresponding diminution in the demand for money (in the broader sense), so that an increase in the objective-exchange value of money must occur."

That is exactly what I've been arguing.

You can find in Mises support for 100% reserves. You can also find in Mises an argument for free banking. You can find in Mises arguments for a monetary equilibrium approach. Both sides can cite Mises. Neither side can claim unambiguously they are taking Mises' position.

Nikolaj:

I see it's time to play "dueling Mises quotes." So here you go:

TTOMAC (312, 1938 edition):

"Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous other is not in a position to enter upon an independent discount policy. If regard to the behaviour of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then - apart from an extension of its clientele - it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange-value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause [i.e., not understanding that it requires competition to work]."

Or try his definitions of inflation and deflation (240):

"In theoretical investigation there is only one meaning that can 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. Again, Deflation...signifies: a diminution in the quantity of money (in the broader sense) which is not offset by a corresponding diminution in the demand for money (in the broader sense), so that an increase in the objective-exchange value of money must occur."

That is exactly what I've been arguing.

You can find in Mises support for 100% reserves. You can also find in Mises an argument for free banking. You can find in Mises arguments for a monetary equilibrium approach. Both sides can cite Mises. Neither side can claim unambiguously they are taking Mises' position.


Steve,

"... you'll have to wait out painful price adjustments to have your higher demand for real balances accommodated."

No, this is not the case at all. Holding money is always a sacrifice in that money held cannot be spent on either consumption or investment.

The primary reason for a workingman to want to increase his holding of money is that his holding balance at the end of a pay period is either uncomfortably small or exhausted completely, after he has both invested and made both predicted and unpredicted purchases over the previous pay period. If he wants/needs to increase his holding of money by $100, all he need do is reduce his total consumption and investment by $100 in just (only) the next pay period. He doesn't need an increase in the money supply from ANY banking organization to satisfy his demand for money. In fact, his increased need for a money holding balance is just as likely as not to be the result of the price increases that have been caused by the bank supply inflation in the first place.

The talk of real balance demand is just noise. For any normal economy, the inflation rate over a pay period is simply too small to count. The workingman will look at the balance in his pocket on payday. If you ask him what inflation rate adjustment he has used to set up his demand for holding money, the best you can hope for is not to have your face laughed in too loudly.

Regards, Don

Steve,

Okay, one more time:

Upon the onset of a recession, in addition to necessary restructuring, the demand to hold money may increase. Because the bust shatters so many expectations, even those who did not malinvest may be spooked, and their perception of risk increases. Money is then seen as a safe alternative to ordinary investments, and the market is flooded with sellers. This "flight to liquidity" disrupts the flow of money which old prices had been predicated upon, and sets in motion a series of adjustments. Unfortunately, the price-discovery process takes time, and some prices, particularly wages, lag badly. In consequence, an economy may become burdened with a glut of unemployed resources, and thrown into political turmoil in the face of high unemployment.

The correct response for a central bank, when faced with a "flight to liquidity", is to lower interest rates. Although this prescription is superficially similar to a Keynesian monetary stimulus, it differs in that its purpose is to calibrate interest rates to the savings rate, because otherwise interest rates would not fall in response the increased demand for money! In a free banking system, meanwhile, these adjustments would take place automatically.

Is that right?

An important question is then: should the Federal Reserve be empowered to respond appropriately to a "secondary recession"? It's a tough call, because the very same powers needed to respond are ripe for abuse.

With regard to free banking, how do you avoid the multiplier problem? I can understand how an individual bank would not issue too much credit, but what happens when other banks loan against money loaned by another bank?

Lee writes:

"The correct response for a central bank, when faced with a "flight to liquidity", is to lower interest rates."

More specifically, increase the supply of money to prevent the market rate of interest from rising above the natural rate as would be the case if the excess demand for money continues. This is more or less what you say here: "it differs in that its purpose is to calibrate interest rates to the savings rate, because otherwise interest rates would not fall in response the increased demand for money!"

Your latter point about giving the Fed the power to respond to the secondary recession being the very same powers that can be abused is *absolutely right*. That's the dilemma of the world of the second best. The power to prevent deflation is the power to generate INflation, as the last 9 months have demonstrated amply.

Your last question requires a read of Selgin's book or some of his follow-up articles. The bottom line is that any individual free bank can only issue the quantity of liabilities that people wish to hold, assuming that it is interested in jointly minimizing the risk of illiquidity and the opportunity cost of foregone loans. If free bank A creates a loan and it gets spent and person B deposits the money in free bank C, free bank A will then have to contract its balance sheet as Bank C comes calling at the clearinghouse, even as C can then expand. It's no different than the very same process we see at work in commercial banks today: the banking system can only create DD = the change in ER x 1/desired reserve ratio.

But overall, as they say, I do believe you've got it!

Don writes:

" If he wants/needs to increase his holding of money by $100, all he need do is reduce his total consumption and investment by $100 in just (only) the next pay period. He doesn't need an increase in the money supply from ANY banking organization to satisfy his demand for money."

I think you're confusing what Yeager called the individual and overall viewpoints here Don.

You are right that if I wish to hold more money, I can simply reduce my expenditures. But if I do that, then it reduces someone else's income, who then finds themselves with less money than THEY wish to hold. What are they going to do? Ultimately, with a fixed money supply, the only way that a desire to hold more money can be met is by prices falling. My reduction in expenditures solves the problem for me, but passes it on to someone else. Of course in normal times, there's no reason to expect that demands for money will tend strongly in one direction or another in the short run. For every person doing this, there may be another spending down his balance so that in the aggregate there are no problems.

And now consider the case where the desire to hold more money is not just scattered in this way, but is systematic. Suppose MANY people wish to hold more money. They can all attempt to do so by restricting their consumption or investment. As they do, they reduce the flow of expenditures and income to LOTS of others, who find themselves not just with less money than they'd like, but with unsold goods and labor. (Excess demands for money imply excess supplies of goods, after all.)

They don't have the income they need to spend, plus they reduce their spending to try to increase their money holdings, passing the problem on to others, etc. The end result is a slow grinding to a halt of the economy until prices and wages get moving. This is the scenario the monetary disequilibrium theorists and the ME-FB Austrians are talking about.

Individuals can always attempt to increase their own money holdings by restricting their expenditures, but one person's expenditures is another one's income, and the attempt to increase individual money holdings will lead to overall frustration.

See Yeager's "Individual and Overall Viewpoints in Monetary Theory" essay.

Class dismissed for the evening :)

Steve,

Thank you for your reply. If I am confusing the individual and overall viewpoints, then they need to be confused. Only individuals act, even if that action is a reaction to some overall central command.

I think that you may have missed my point that the reduction in consumption and investment of $100 need only occur for a single pay period, after which the rates of investment and expenditures can return to their previous levels.
The $100 could also come from the sale of an asset, but that's a side issue.

Does the reduction of $100 impact vendors? Of course, but the level of the impact is important.

When MANY people all want to increase their money holdings, the most likely cause is the inflationary money supply increase of the banks that drives up almost all market prices, and leaves the individual worker out of money at the end of his pay period unless his wages rise as fast as prices, ignoring the question of retirees on fixed incomes. Please suggest another cause for a large synchronized increase in the demand for money besides bank supply inflation or a gross incompetence that leaves everyone in fear for their economic lives. It seems to me that increasing the supply of money to try to satisfy a demand for money is largely a 'chasing-its- tail' phenomena.

Regards, Don

Steve:

Excellent post regarding there is no free lunch. (Perhaps there are difficulties in adjusting nominal quantity of money to demand, but there are also difficulties in prices adjusting the real quantity to real demand.)

Suppose uncertainty causes an an increase in the real demand for money. The nominal quantity is fixed, and the price level falls. Forget whether it is painful or not. Real output and employment recover at the low price level. Why? Well, there is the pigou effect on consumption--more real balances, more real wealth, less saving and more consumption. And there is the more standard real balance effect, more real balances, more security pruchases, lower nominal interest rates. Or, if the price level falls enough, below the expected future price level, then real interest rates fall.

All of these things result in more real expenditures on various things, and so production and employment recover at a lower price level.

To me, there is little reason to beleive that the pattern of real expenditures generated in this scenario have no particular reason to be described as optimal. Consumption due to extra high real balances? Investment due to low real interest rates because of expected inflation? Extra low nominal interest rates because of high real balances? (I think I am focusing on the piguou effect and an consumption led recovery, but I also think the pattern of intestment might be different with it being driven by high real balances despite tremendous uncertainty.)

Anyway, the economy has recovered in real terms. Why the uncertainty? And so, suppose the demand for money falls. The price level rises now (or purchasing power of money falls.)

People rush out of money holdings to avoid reall loss. The allocation of resources are somehow optimal?

Obviously, I am not making these points to criticize your arguments...I suppose it is an arugment against the purported optimality of having the real quantity of money adjust to the real demand for money.

Kelly:

In your comments above, you describe the central bank as lowering interest rates in response to additional uncertainly.

Steve agreed, but pointed out that _if_ there is an increase in the demand to hold money, then then an increase in the quantity of money created by the banking system is the best response, rather than having the given quantity of money increase in value though a decrease in the price level. Interest rates should adjust to clear the supply and demand for credit.

I would like to add that added uncertainly may have all sorts of impacts on credit markets. In my opinion, the last year or so have proven that great care must be used in "single interest rate" as a simplifying tool. While interest generally move together--apparently reflecting changes in some underlying phenomenon along with a dispersion of interest rates reflecting differnet risk premia... sometimes there can be significant changes in those risk premia. So, for example, BAA corporate bond interest rates rise while 4 week Treasury bill rates fall nearly to zero. what is happening to _the_ natural interest rate in such a scenario?

"The other key to the puzzle is to recognize that even in an unhampered market, prices don't instantaneously and perfectly react to changes in demand and supply. There is a discovery process that involves lags/stickiness. If you grant that, then the decision by many market actors to hold more money by reducing expenditures can lead to a period of economy-wide excess supplies as prices and wages don't immediately and perfectly fall. Nothing mystical there, just the imperfect market discovery process that Austrians have talked about since Menger."

Wrong, This has nothing to do with Mengerian insight into functioning of markets, but with Keynesian belief that you can manipulate people from outside the market, to fine-tune the system. That using bank and governments you can "immprove" markets, i.e. remove stickiness of prices and other defects of market. It is not problem for me to concede that people can be irrational sometimes, and hold more money than they actually need. The problem is that YOU think you always can be rational, as an outside observer or central monetary planner to correct that irrationality of people. All interventionist always point to "irrationality of the people" as an argument for intervention. You are developing just one more sort of market failure theories. That has nothing to do with Menger's or Hayek's general points about functioning of markets, but with typical Keynesian belief (White and Selgin even concede that Keynesian have no reason to protest against their free banking recipes)that quantity of available capital can be increased by simply increasing credit inflation, i.e. fiduciary media issuance to satisfy "demand for money". Hayek explained that fact that people do not know many things is the argument that we need more market as an instrument of collecting more information than any individual has, and not more government intervention, to rectify consequences of their insufficient knowledge. Your approach in this regard is much closer to that of Stiglitz, than to Hayek.

As for Mises, he always was supporter of 100% gold standard, and believed free-banking could be only temporarily transition phase to 100% system. You have pretty good overview with many citations here http://mises.org/books/desoto.pdf
and here http://mises.org/journals/rae/pdf/RAE6_2_5.pdf

Well Nikolaj, you can continue to stamp your feet like a child and insist that I'm a statist/Keynesian/central planner. That won't make it true. (Of course, perhaps Keynes was right about a few things - horrors! gasp!) I find it downright bizarre that you continue to insist that I am arguing that people are irrational, or that their increases in the demand for money are "irrational hoarding" when I have explicitly denied it, both here and in published work. I really think you aren't reading/understanding my previous comments very well.

And as for Mises, I suggest you check your copy of Human Action (1966, p. 443):

"Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions."

And the context is utterly clear that he means exactly what White, Selgin, Horwitz et. al. mean by it, right down to fractional reserves. There's no talk of transition or anything else. Just a plain, straight-out defense of free banking as the ideal in his most famous book.

Yes, there are places that he appears to support 100% reserves. As I said before, it's not unambiguous, but it is YOU, not me, who is arguing that he only held one clear position. Mises *did* defend free banking and was NOT "always a supporter of the 100% reserve gold standard." Again, you can stamp your feet all you want, but it doesn't change what Mises said.

Only you are the one who wants to use government to force rational individuals to hold less money than they voluntarily desire by artificialy restricting supply.

In case is of interest, I would like to add a reference of Mises to that of Prof. Horwitz.

In Theory of Money and Credit, in Part IV, in Chapter 22 Mises says (1981 p. 482):
"Suspension of the banknotes’ convertibility and legal-tender provisions had transformed ‘hard’ currencies of many countries into questionable paper money. The logical conclusion to be drawn from these facts would have been to do away with privileged banks altogether and to subject all banks to the rule of common law and the commercial codes that oblige everybody to perform contracts in full faithfulness to the pledged word. *Free banking would have spared the world many crises and catastrophes.*"

This is before chapter 23 "The Return to Sound Money." In that section Mises seems to recommend the marginal 100-percent rule to issuer banks, not commercial banks, which means no abolition to the possibility of fractional reserves by the second ones.

What I'm trying to say is that Mises' first best was free-banking with no imposition of the 100-percent rule, but in the presence of Central Banks his second best is a rule limiting the expansionay policy of monopolistic issuer banks; which won't be needed in a free-banking, as he explained in Human Action's Chapter XVII.12 (from where Horwitz's quote comes from).

A reading of Mises could be done where he prefers free-banking in "Theory of Money and Credit," "Human Action," and also in the last edition of "Theory of Money and Credit."

If it's of interest, a draft with a different reading of Mises to that of Prof. Huerta de Soto on the 100-percent rule: http://ncachanosky.files.wordpress.com/2008/03/mises-on-fractional-reserves-a-review-on-huerta-de-sotos-argument-v7.pdf

Bests,
NC

The comments to this entry are closed.