Reply to Salerno's Four Propositions on Mises and the Free Banking School

Steven Horwitz

Over at the Mises Blog, Joe Salerno has responded to my original reply to him.  Let me first agree with Pete's call in the comments on the last post that the real issue here is dealing with what the real world is throwing at us right now and not endlessly debating amongst ourselves.  So with that said, this will be my final substantive comments on this debate. 

Joe has done this debate a great service by laying out his challenge in the form of four propositions of the Free Banking School that he believes are not accepted by Mises.  He wants to see textual evidence of Mises's support for them.  They are:

1. the creation of fiduciary media does not cause a business cycle when the additional quantity matches an increase in the demand for money;

2. in the absence of the creation of fiduciary media, an increase in the demand for “inside” (bank notes and deposits) money will lead to a rise in the loan rate of interest above the natural rate of interest thus causing a depression (or conversely, a fall in the demand for money unmatched by a contraction of fiduciary media will depress the loan rate below the natural rate and precipitate a business cycle);

3. a regime of free banking will lead over time to progressively lower reserve ratios for bank notes and deposits;

4. the goal and program of the Currency School was fundamentally misconceived.Such statements would indeed mark Mises as a forerunner of the Selgin-White neo-Banking School. However I have not seen them.

Below the fold I reprint Joe's comment in bold and intersperse my responses to each of those propositions.

The real issue as I tried to make clear in my two posts is that from his very first work in monetary and business cycle theory to his very last discussion of the issue in Human Action Mises never deviated from two views. The first was that the creation of fiduciary media under any and all circumstances caused a downward deviation of the loan rate from the natural rate leading to the sequence of phenomena known as the business cycle. The second was that free banking was the best policy available for bringing about the goal of the Currency School and Peel’s Act which was the eradication of the of issuance of fiduciary media. In fact Mises’s primary aim was to revive Currency School approach in theory and formulate a means to effectively achieve their policy goal. Given the evidence I have adduced in my first post and that Nicholaj and others have presented, there is no longer any question that Mises unwaveringly maintained these views.

Now you open your post with the following statement: “As passionate defenders of a position often do, Joe has presented the pieces of the story that are congenial to his view and chosen to ignore those that are not.” Who cares if someone is a “passionate defender” of a position or if someone is jaded defender of a long held position that he has a reputational stake in? What I would like to read from you or anyone else are citations to statements by Mises which explicitly argue that:

1. the creation of fiduciary media does not cause a business cycle when the additional quantity matches an increase in the demand for money;

It is true enough that Mises never says this as clearly and concisely as Joe has put it here. However, as I note below, Mises was clear, even as late as Human Action, that the mismatch in the market and natural rates of interest was generated by “cash-induced changes in the money relation” where the “money relation” is defined as the relationship between the supply and demand for money. (HA, p. 411) He says that relation determines money’s purchasing power as well. All of this is very consistent with Mises’s Wicksellian roots.

If we further agree that it is inflation that triggers the business cycle by distorting the money relation from the cash side and driving a wedge between the market and natural rate, we will need to look to Mises’s definition of inflation for some help. And in both The Theory of Money and Credit and a 1951 lecture, Mises defined inflation as an excess supply of money:

“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.” (TTOMAC p. 240 in the 1952 version, ch 7 section 7, or p. 272, 1980 Liberty Press edition, my emphasis)

And in 1951: “Inflation is an increase in the quantity of money without a corresponding increase in the demand for money, i.e., for cash holdings.” That was at a set of lectures given at FEE.

And a year later, Mises said:

“Therefore the dangers of credit expansion were not very great as long as the credit expansion was the business of private banks and private businesses subject to commercial laws. As long as the surplus banknotes could be returned to the bank of issue for redemption, there was a check on credit expansion, and there couldn't be credit expansion of any considerable extent.”

There is no way to understand his use of the word “surplus” in that last sentence except as “in excess of the demand to hold them” given his earlier definition of inflation and given that the context is the question of being returned for redemption and the concept of adverse clearings.

If you add up all of these statements, they are consistent with the statement Joe lays out in 1) above:

Premise 1: for there to be a business cycle there must be inflation as only that can drive the market rate below the natural rate

Premise 2: inflation requires the supply of money including fiduciary media to be greater than the demand to hold it

Minor conclusion: Then an increase in the supply of fiduciary media that matches an increase in the demand to hold them is not inflationary

Therefore: an increase in the supply of fiducidary media that matches an increase in the demand to hold them does not trigger the business cycle. QED

So no, Mises never said it explicitly, I will grant Joe that. But it is, in my view, a logical conclusion to draw given a number of other things he does say. If there’s a flaw in my logic here, I’m sure Joe will let me know about it. I think Mises’s direct words, however, are pretty clear and pretty consistent from 1912 to 1952 to 1966.

2. in the absence of the creation of fiduciary media, an increase in the demand for “inside” (bank notes and deposits) money will lead to a rise in the loan rate of interest above the natural rate of interest thus causing a depression (or conversely, a fall in the demand for money unmatched by a contraction of fiduciary media will depress the loan rate below the natural rate and precipitate a business cycle);

In Human Action (p. 547), Mises writes:

“Cash-induced changes in the money relation can under certain circumstances affect the loan market before they affect the prices of commodities and labor. The increase or decrease in the supply of money (in the broader sense [which includes fiduciary media – SH]) can increase or decrease the supply of money offered on the loan market and thereby lower or raise the gross market rate of interest although no change in the rate of originary interest has taken place. If this happens, the market rate deviates from the height which the state of originary interest and the supply of capital goods available for production would require. Then the market rate of interest fails to fulfill the function it plays in guiding entrepreneurial decisions.”

Although my langauge is different, it might be worth comparing that passage with something from my 2000 book in which I’m discussing the way in which inflation and deflation cause the market rate to deviate from the natural rate in the way Joe’s point 2 describes:

“[M]onetary equilibrium is that situation where relative price signals, particularly intertemporal ones [i.e. interest rates – SH], are accurate enough to allow entrepreneurs to create a potentially sustainable capital structure. … One of the primary effects of both inflation and deflation is to distort the price signals that lead to the integration of the intertemporal structure of production… A systematic unsustainability in the capital structure suggests that the ruling market rate of interest is not equal to the natural rate.” (Horwitz 2000: 82)

I submit that my argument is identical in its essentials to Mises’s.

Furthermore on pages 548-50, Mises has a discussion of the effects of inflation upon originary interest. He concludes by saying “The same is valid, with the necessary changes, with regard to the analogous consequences and effects of a deflationist or restrictionist movement.” That certainly suggests strongly that Mises saw deflationary process as reversing all the relationships of the inflationary one, including the relationship between the market and natural rate.

And on p. 566-7 (my emphasis) of Human Action, Mises discusses deflation explicitly:

“In all of these cases [the ways in which deflation might happen] a temporary tendency toward a rise in the gross market rate of interest ensues. Projects which would have appeared profitable before appear so no longer. A tendency develops toward a fall in the prices of factors of production and later toward a fall in the prices of consumers’ goods also. Business becomes slack. The deadlock ceases only when prices and wage rates are by and large adjusted to the new money relation. Then the loan market too adapts itself to the new state of affairs, and the gross market rate of interest is no longer disarranged by a shortage of money offered for advances. Thus a cash-induced rise in the gross market rate of interest produces a temporary stagnation of business. Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities.”

Mises then goes on to explain why deflation and inflation are not “simply counterparts,” a discussion that I largely agree with as he points out that deflation is generally not as destructive as inflation.

It’s also worth noting the italicized sentence, which suggests that Mises saw that deflation led to a downward “tendency” on prices and wages but that there was first a “deadlock” that only ceased after some period of adjustment. This is more or less exactly what monetary equilibrium folks have been arguing about the imperfect flexibility of prices during a monetary deflation.

The bottom line is that Mises did recognize that a monetary deflation (understood as a supply of money less than the demand to hold it, as he defined it in TTMOAC) could drive the market rate above the natural rate and lead to a recession.  I think that addresses Joe's proposition.

3. a regime of free banking will lead over time to progressively lower reserve ratios for bank notes and deposits;

This one I will concede as he does say in several places that he thinks the reverse will happen. I think Mises was wrong here but, on this count, he’s inconsistent with the modern Free Banking School.

4. the goal and program of the Currency School was fundamentally misconceived.Such statements would indeed mark Mises as a forerunner of the Selgin-White neo-Banking School. However I have not seen them.

First of all, Selgin and White are not a “neo-Banking School” as both have argued in print and online.  See George's “The Analytical Framework of the Real Bills Doctrine,” JITE, 1989 and Larry's discussion in Free Banking in Britain.  Both of them reject the Real Bills Doctrine and the Law of Reflux that were the defining characteristics of the Banking School.  To label them (and me) as a "Neo-Banking School" is utterly at odds with the plain text of our work.

In his reply at Division of Labor Larry offers a better response to Joe's number 4 than I could:

“Not recognizing a distinct Free Banking School, Mises did claim kinship with the Currency School. The Currency School, like the Free Banking School, recognized that a central bank (the Bank of England) could and did instigate booms by over-expanding its liabilities, and that the expansion proved unsustainable under a gold standard due to losses of gold reserves to the rest of the world. Mises effectively sided with the Free Banking School against the Currency School, however, in rejecting the standard Currency School view that an unprivileged competitive banking system systematically tends to overissue to such an extent that legal restrictions are needed to suppress it. The Currency School favored not only the imposition of a 100% marginal gold reserve requirement on the Bank of England’s note issue but also the suppression of note-issue by other English banks, because they considered the competing banks outside London an additional source of overissue. They shared none of Mises’ insights about the benefits of free banking in preventing overissue through adverse clearings among competing banks that cannot collusively coordinate their behavior.”

Thus Mises did, in fact, reject a key element of the Currency School view. It’s a matter of interpretation as to whether that element is “fundamental” enough to say the whole program was misconceived. I think that element is pretty gosh darn important and Larry’s commentary above would suggest that as well. But if Joe thinks it’s not that fundamental, then so be it. In any case, Mises’s defenses of free banking and his understanding of the adverse clearing process in such a system mark a clear difference with the Currency School.

We of the neo-Currency School have presented you with abundant evidence that Mises made numerous statements throughout his career that explicitly and forthrightly contravene each and every one of these propositions. It behooves you to cite the evidence that you claim makes Mises’s position on these issues so ambiguous. In the absence of such statements by Mises, I believe we should consider the debate over and move on to substantive issues in disentangling the two schools.

I think I have sufficiently met Joe's challenge in three of the four propositions he put forward. In the first case, there's no explicit statement by Mises but it is the only logical conclusion one can draw from other explicit statements he makes.  Propositions 2 and 4 are, in fact, explicitly stated by Mises. I happily concede Joe's third proposition and gladly admit that, on that issue, Mises cannot be considered part of the Free Banking School. However, I think I’ve met Joe's challenge in the case of the other three. At the very least, this should demonstrate the ambiguity in Mises. However, I think it does more than that and actually shows that, to use my earlier phrase, “the preponderance of the evidence” supports the Free Banking School interpretation. Joe gave me four propositions, I provided evidence for three. That’s a “preponderance” in my book.

As I said at the start, I will make no more lengthy posts on this topic, though I reserve the right for a brief comment or two.  I will be offline quite a bit the next couple of days, so do not take my silence as anything more than that.

Comments

[Dan]

Steve,

No doubt, if you were on trial, and we apply the standard of "beyond any reasonable doubt" for conviction, then you could have made what may have seemed to the "right" jury, a rather compelling case for your acquittal.

But Steve, come on. In nearly 60 years of Mises' career, the above is all you can find, and for which you are also forced to acknowledge that Mises isn't explicit and requires your further elaboration and somewhat interpretation. This in light of all of the unambiguous and numerous damning and explicit statements against the issuing of any amount of fiduciary media, as even Larry White is forced to acknowledge, and many of which are in the same texts as from where you have extracted the above quotes.. and yet you still insist that “the preponderance of the evidence supports the Free Banking School interpretation.

I don't know, but I don't think you can ever win this argument on pure substance. Not even that Mises was ambiguous. Sure here and there (count it on one hand) there are a few ambiguous statements, most of them have just been posted by you. A few statements do not somehow make the vast amount of literature in the course of 60 years ambiguous. No way!

[Lawrence H. White]

Probably the clearest statement by Mises favoring fiduciary media and opposing measures to ban them comes in the section of The Theory of Money and Credit titled "The Case Against the Issue of Fiduciary Media". There Mises sets forth the main good reasons why proposals for 100% reserves have not been adopted:

"The progressive extension of the money economy would have led to an enormous extension in the demand for money if its efficiency had not been extraordinarily increased by the creation of fiduciary media. The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus. Fiduciary media tap a lucrative source of revenue for their issuer; they enrich both the person that issues them and the community that employs them."

[Nicolas Cachanosky]

I'm not sure I can add too much to all that have already been said in so many comments in differents posts. Nevertheless I'd like to share three quotes from Mises on this topic which, I think, show that Mises saw no problems with fiduciary media per se. One on the need of fiduciary media for banking to be sustainable and the second and third ones on Peel's Act:

"Issuing money-certificates is an expensive venture. The banknotes must be printed, the coins minted; a complicated accounting system for the deposits must be organized; the reserves must be kept in safety; then there is the risk of being cheated by counterfeit banknotes and checks. [A]gainst all these expenses stands only the slight chance that some of the banknotes issued may be destroyed and the still slighter chance that some depositors may forget their deposits. *Issuing money-certificates is a ruinous business if not connected with issuing fiduciary media. In the early history of banking there were banks whose only operation consisted in issuing money-certificates. But these banks were indemnified by their clients for the costs incurred.* [A]t any rate, catallactics is not interested in the purely technical problems of banks not issuing fiduciary media. The only interest that catallactics takes in money-certificates is the connection between issuing them and the issuing of fiduciary media." (HA 1949 [1996], p. 435).

This citation comes from the free banking chapter in HA, where he's not working under the assumption of a central bank.

The second one (on Peel's Act):
"To start from the Banking Principle, which denies the possibility of an over-issue of bank-notes and regards 'elasticity' as their essential characteristic, is necessarily to arrive at the conclusion that any limitation of the circulation of notes, whether they are backed by money or not, must prove injurious, since it prevents the exercise of the chief function of the note-issue, the contrivance of an adjustment between the stock of money and the demand for money without changing the objective exchange-value of money." (TOMC 1912 [1981], pp.406-407)

The third one (also on Peel's Act):
"*As far as Peel’s Act was concerned, however, this very shortcoming of the theory that had created it turned out to be an advantage; it caused the incorporation in it of the safety valve without which it would not have been able to cope with the subsequent increase in the requirements of business.* The fundamental mistake of Peel’s system, which it shares with all other systems which proceed by restricting the note circulation, lies in its failure to foresee the extension of the quota of notes not backed by metal that went with the increase on the demand for money in the broader sense. As far as the past was concerned, the act sanctioned the creation of a certain amount of fiduciary media and the influence that this had on the determination of the objective exchange value of money; it did not do anything to counteract the effects of this issue of fiduciary media. But at the same time, in order to guard the capital market from shocks, it removed all future possibility of partly or wholly satisfying the increasing demand for money by the issuing of fiduciary media and so of mitigating or entirely preventing a rise in the objective exchange value of money. *This amounts to the same thing as suppressing the creation of fiduciary media altogether and so renouncing all the attendant advantages for the stabilization of the objective exchange value of money. It is an heroic remedy with a vengeance, in essence hardly differing at all from the proposals of the downright opponents of all fiduciary media.*" (TOMC 1912 [1981], p.408)

These two last citations comes from the addendum in TOMC, and are from a specific chapter on Peel's Act. He's explicitly sustaining that 1) "Issuing money-certificates is a ruinous business if not connected with issuing fiduciary media; 2) "is necessarily to arrive at the conclusion that any limitation of the circulation of notes, whether they are *backed by money or not*, must prove injurious" and 3) that what Peel's Act tries to do "amounts to the same thing as suppressing the creation of fiduciary media altogether *and so renouncing all the attendant advantages for the stabilization of the objective exchange value of money*."

The link, with the ABCT, as I interpet Mises's position, is when a monetary authority (i.e. a central bank) expands fiduciary media more than the increase in its demand, and not that just any expansion in fiduciary media results in ABCT; even if he wasn't explicit and 100% clear on this (just as he wasn't on the opposite). I found plausible the interpretation that his references and proposals to limit issuance are with a central bank (or monetary authority) with a bias to over-expand as given as a "second best".

Hope this helps rather than adding more confussion.

Best,
NC

[TGGP]

Bob Murphy thinks the statements quoted aren't at all inconsistent with a 100% reserves position:
http://consultingbyrpm.com/blog/2010/05/believing-is-seeing-free-banking-controversy.html

I know he commented in the last post, but I figure a post from his own blog sums up the case better. And it's also directed at Larry White, so we don't need to wait for Steve to rejoin.

[Dan]

Steven,

Regarding #2, you clearly have nothing.

The elevated market rate of interest above the natural rate refers to the reverse process of credit expansion, that is, Credit contraction! Obviously, when fiduciary media are withdrawn from the system, the cash induced changes elevate the market rate above the natural rate just as during the expansion phase, the cash induced changes depressed the market rate below the natural rate. So again, interest rate is distorted due to fiduciary media.

The quote you provided from HA makes it very clear and read in the full context of that section, it is unambiguously crystal clear. You're now basically defending fiduciary media in order to solve a problem originally caused by fiduciary media.

[Bill Woolsey]

Dan,

I don't understand.

Suppose the demand for money rises and people sell bonds to accumulate money. Or perhaps they reduce their customary purchases of bonds out of current income. More of their savings are used to accumulate money rather than buy bonds.

The lower demand for bonds lowers their prices and raises their yields. The market interest rate rises.

The supply of saving has not fallen. The demand for investment hasn't risen. The natural interest rate is unchanged.

The market rate is above the natural rate. This creates a signal and incentive for housholds to increase their saving--purchase fewer consumer goods. It also creates a signal and incentive for firms to purchase fewer capital goods. Generally, the demands for more interest elastic goods fall more and the demands for less interest elastic goods and services fall less. There is a change in the composition of demand and relative prices.

But, once prices fall enough, the real supply of money rises again. Leaving aside changes that occur in the meantime, the demand for bonds rises again. The market interest rate falls back to the natural interest rate. The quantity of saving supplied falls and the demand for investment rises.

Back to equilibrium, but the process including the market interest rate rising above the natural interest rate.

How is this process impossible?

[Bill Woolsey]

I think Mises looked out at the world and saw central banks pegging money rates below the natural interest rate. I am not saying that vision was realistic. But that assumption explains why he was always complaining about "fiduciary media." An excess supply of money is the normal state of the modern world. Sure, if fiduciary media were limited to the demand to hold them, then there wouldn't be a problem. But if we want to understand what is happening in the world, we need to focus on the situation where the excess supply of fiduciary media is massive. The unusual case where there isn't a problem can be mentioned in passing.

[Bob Murphy]

Like Steve I am going to bow out of this at least for a while too. I just want to go on record here saying that the quotes provided above by Nicolas Cachanosky look pretty good for the White/Horwitz position. I would need to read them in context before surrendering, but at least those quotes appear to prime facie confirm what White/Horwitz have been claiming.

In contrast, the Mises quotes supplied (in the last few days, not necessarily over the last few years) by Horwitz and White haven't even struck me as inconsistent with Salerno's position.

[Dan]

Bill,

Your assertion about "supply of savings not falling" when people increase their cash holding is correct only as long as the proportion of spending between present and future goods does not change. So you cannot just talk to me about people cutting their spending investments goods (selling bonds, stocks, etc..), because if spending on consumer goods remained the same, then the natural rate really does rise since the new proportions of spending indicate a more present oriented time preference. So in your example, you must also mention the cut in spending from consumers goods, And in such a case, where the proportion remains the same, there is no market rate higher then natural rate. Interest rate will tend to remain the same. Hold that thought, let's continue.

You say:

"The lower demand for bonds lowers their prices and raises their yields. The market interest rate rises."

True, it lowers their prices but you're mistaken about their yields for you have not considered the fall of prices of consumer goods also. Changes in yields result from changes in relative prices, and not nominal prices. If time preference doesn't change as people increase their cash holdings, prices will tend to fall evenly throughout the entire economy. The fall in prices of the bonds results from a higher purchasing power of the money unit and not because there is a relative lower demand for it. So yields will tend to remain the same.

Your entire perspective on capital theory, in my opinion, is wrong.

[Current]

Some quotes that may be of interest in this debate...

On page 39-40 of "The Causes of Economic Crises" Mises talks briefly about the situation *after* his monetary reconstruction proposals have been performed:

"Notes of any kind over and above this amount must be fully covered by deposits of gold or foreign exchange in the Reichsbank. As may be seen, this constitutes acceptance of the leading principle of Peel's Bank Act, with all its shortcomings. However, these flaws have little significance at the moment. Our first concern is only to get rid of the inflation by stopping the printing presses. This goal, the only immediate one, will be most effectively served by a strict prohibition of the issue of additional notes not backed by metal.
Once adjustments have been made to the new situation, then it will be time enough to consider:
(1) On the one hand, whether it might not perhaps be expedient to tolerate the issue, within very narrow limits, of notes not covered by metal.
(2) On the other hand, whether it might not also be necessary to limit similarly the issue of other fiduciary media by establishing regulations over the banks' cash balances and their check and draft transactions.
The question of banking freedom must then be discussed, again and again, on basic principles. Still, all this can wait until later."

Page 130 of "The Causes of Economic Crises":
"The alternatives are not merely restriction or freedom in the issue of fiduciary media. The alternatives are, or at least were, privilege in the granting of fiduciary media or true free banking."

Page 161 of "The Theory of Money and Credit" (Lib fund edition): "An increase in the amount of fiat or credit money is only to be regarded as an increase in the stock of goods at the disposal of society if it permits the satisfaction of a demand for money which would otherwise have been satisfied by commodity money instead, since the material for the commodity money would then have had to be procured by the surrender of other goods in exchange or produced at the cost of renouncing some other sort of production."

[Mikeikon]

As interesting as this discussion is in terms of history of thought, I can't help but feel that there's way too much emphasis on "what Mises thought" or "what Rothbard thought." Why must we limit ourselves to what these figures in the Austrian movement happened to think about these issues? What's important is not what Mises thought, but what is true.

Even if Mises or Rothbard were wrong on banking, it doesn't mean they were fools or that you can't appreciate all the stuff they got right. People are fallible. Don't be so stubborn and dogmatic as to put these men on a pedestal above the truth. Think for yourself. If your conclusions don't line up with their conclusions, then so be it.

The stuff I've been hearing from the Mises blog on this issue has made me much more skeptical of scholarship in the Austrian school. If you want to fix that, stop bickering over 'he said she said' and start debating some real economic theory.

[Oderus Urungus]

"If you want to fix that, stop bickering over 'he said she said' and start debating some real economic theory."

Why do you single out the Mises blog for this kind of thing? It's on full display here, I would say.

[Nicolas Cachanosky]

@Bob Murphy,

Thanks, I'm glad you found the quotes interesting.

In case you might be interested in a more extensive and detailed work than can be expressed in a blog comment:
http://ncachanosky.files.wordpress.com/2010/05/mises-on-fractional-reserves-a-review-on-huerta-de-sotos-argument.pdf

Best,
NC

[Current]

I'm not sure this debate is that useful for discussing the supposed subject of the debate - Mises' view. But I think it is useful for discussing the 100% reservist vs fractional reservist argument.

[Current]

I'm still dilly dallying about what side of this Mises debate I'm really on. Though I definitely agree with the Free banker's view of monetary theory.

One thing I must say about it though is that when reading Mises you have to take his definition of deflation and inflation seriously. In the present time we are used to considering "inflation" to be either price inflation or the creation of money. In Mises time it really wasn't that clear, that's why Mises gave his own definitions in "The Theory of Money and Credit" which are MET in nature.

Larry White and Steve Horwitz aren't stretching things to say that when Mises refers to inflation and deflation later he is referring to his own definitions of them. It may feel natural to us now to when reading a quote of Mises to read "inflation" as meaning "price level rise" or "money creation", but that's just because we've read later books.

[The_Orlonater]

I'm going to side with Current on this opinion, but it is rather fun quarreling over what Mises said.

[Bill Woolsey]

Dan:

I am aware of the difference between real and nominal interest rates.

The shift from bonds to money is not a shift in time preference. Money is an asset and just like bonds, allows for increased future consumption when the money is spent. It is a substitution from one asset to another.

You assert that if the demand for money rises and time preference has not changed, prices will fall. I don't know what time preference has to do with it. If the demand for money rises and the nominal quantity of money doesn't rise, then the price level will be lower.

Anyway, that is the equilibrium condition. What is the market process that causes prices to fall? In the scenario I described, the market process included the market interest rate rising above the natural interest rate.

If prices are expected to fall and the nominal rate is given, then the real rate rises. If the nominal rate rises and prices are expected to fall, then the real rate rises more.

Saving is a flow--the difference between two other flows, income and consumption. Consumption is spending on consumer goods.

The supply of saving is the relationship between real interest rates and this flow of saving. Given income, less saving is more consumption, and so it is simultaneously a relationship between real interest rates and consumption.

If anything other than a lower real interest rate results in people choosing to saving less and consume more, (given income) that is a decrease in the supply of saving.

If people sell bonds to accumulate more money, bond prices fall and their nominal yields rise. If people expect deflation of prices, then this increases their real yields by more than the nominal yields. The nominal yields are not really given, and the point is that real yields rise.

This does not involve a decrease in the supply of saving. People have not chosen to consume less and save more. There has been a shift in the way people hold existing wealth--less bonds and more money. The flow of consumption and saving out of current income was not impacted immediately.

However, the increase in the real market interest rate leads to an increase in the quantity of savings supplied. This price signal creates an incentive to spend less income on consumer goods.

When bond prices fell and their yields rose, this increased the demand to hold bonds. The other side of that coin was households spending less on consumer goods and buying those higher yielding bonds.

I also said that an increase in the real market interest rate leads to less investment demand. Investment demand is also a flow concept. It is spending by firms on capital goods. Higher interest rates reduce investment demand.

Some of your remarks seem to suggest you understood me to mean that this had to do with stocks and bonds. Maybe not, but that isn't what I was talking about.

The natural interest rate is the level of the real interest rate that keeps the flow of saving equal to the flow of investment. That part of income not spent on consumer goods is matched by spending on capital goods. Income and output are equal. The flow of current output generates a flow of current income to those contributing to the production of the output.

The flow of current output is made up of consumer goods and capital goods. When the real market interest rate equals the natural interest rate, the flow of real expenditure on consumer goods and capital goods matches up with the production of consumer goods and the production of capital goods. Saving equals investment. That part of income not spent on consumer goods is spent on capital goods.

If the market interest rate is above the natural interest rate, then incorrect signals are being given and incorrect incentives are provided. The households demand fewer consumer goods and instead accumulate more assets like money, stocks and bonds. The firms, meanwhile, demand fewer capital goods. The real flow of expenditure on consumer goods and capital goods together is less than the real flow of income and output.

Now, perhaps this is all based upon bad capital theory. I know it is based on simple capital theory. But that is all that I think is necessary for this purpose.

But if you insist, I can add that the firms are getting a signal that they should shorten the structure of production and use less round-about methods of production.

At the same time, the households are getting the signal that they should postpone consumption to free up existing resources for round about processes that will only mature in the more distant future.

These signals are inconsistent. The natural interest rate is the level of the real interest rate that gives the right signals and incentives. Households consume and save and add to net worth in a way consistent with firms producing consumer goods for now, and also producing various capital goods that make up various round about processes to produce consumer goods in the future. The households accumulated net worth will provide them with means to purchase those additional consumer goods provided when the round about processes mature.

I am well aware that this gets even more complicated very quickly. I have seen nothing that you have written that suggests you have an inkling of the complications in involved in capital theory.

Well, keep on reading about economics. I am sure it will become clearer as you learn more.

[Dan]

Bill,

"You assert that if the demand for money rises and time preference has not changed, prices will fall. I don't know what time preference has to do with it"

Evenly! Prices will tend fall evenly, or perhaps I should have said tend to fall uniformly.

Look, you are the one who has initially defined the problem such that time preference remains unchanged as demand to hold money increases.
But then the conditions for the problem as you propose them are invalid. Right from the start you make the mistake of talking about people increasing their cash balances by refraining from spending on investments goods only. Well then this example of yours immediately shows your utter confusion in the Hayekian framework of Capital theory. This situation cannot possibly occur without an increase in the natural rate, so I had to correct you and alter your problem so that cash balances are increased by cutting spending from both investments AND consumers goods.

If you cannot understand this elementary part of capital theory, or perhaps you do but you seem to reject it, then I'm afraid that to continue to debate the remaining analysis is useless.

Now, it is perfectly fine for you to debate by using a different framework, however, I am really puzzled by you and some other here to insist that you are consistent with Austrian capital theory. It shows that you, or one of us if you like, is completely off the mark.

Now, since you ended by trying to make a gain on me by resorting to your own authority, I will also say that my position is fully compatible with critics of ME/FB made by prominent Austrian theorists such as de Soto, Salerno, and others, and I also contend that the framework I used to criticize you are fully consistent with Hayek and Rothbard. The framework you are using is some sliced up capital theory combined with Monetarism. A complete incoherent mess if you ask me.

[Lee Kelly]

Mises's concern with large and sudden changes in the objective exchange rate of money for other goods seems important. Is Mises's "objective exchange rate" merely a Misesian reference to the general level of prices? Surely Mises did not believe that the exchange rate of money should be stable relative to any particular good. It seems to me that he must have been thinking about the average exchage rate, because the average can remain stable while particular prices change.

Isn't this concern with the average exchange rate of money for other goods merely a recognition that a medium of exchange should neither appreciate nor depreciate?

It seems to me that Rothbardians like bad money during a recession, i.e. they claim deflation is good. But an increase in the average exchange rate of medium of exchange would surely frustrate its ability to serve as a medium of exchange, right? Any good that suffers from large and sudden appreciation (or depreciation) in its average exchange rate is not going to be sold (or bought) as frequently as before. In a competitive environment for money, some other good would begin fulfilling the role of money instead.

[Bill Woolsey]

Dan:

It has been many years since I read Hayek's Pure Theory of Capital. I found it tough going.

You have a complete understanding?

What I think is that you are confusing Austrian capital theory with Rothbard's interpretation of Mises' pure time preference theory of interest. You are also balling this up with Rothbard's refusal to see that money is an asset so that using income to accumulate money is saving. The way Rothbard looks at it, there is money and then there are present goods and future goods.

This is the source of your argument that a shift from "investment goods" to money must be an increase in time preference and so the natural interest rate. That isn't capital theory. It is Rothbard's monetary theory.

Most economists, including me, count money as an asset, so that accumulating money is saving. Using income to accumulating money, accumulate some financial asset, or even paying down debt are all different ways of saving. This is a flow. This flow of saving builds up net worth. Net worth is assets minus liabilities. It is a stock. Building up wealth now allows for increased future consumption. Dissaving is when you reduce net worth, and consume more than income. Reduced future net worth reduces future consumption. Time preference involves the value of present vs. future consumption. A shift from bonds to money is not a shift from future consumption to present consumption.

Investment is the machines, buildings, and equipment. Households can buy them and rent them to firms. And firms can retain earnings, save for the owners, and buy capital goods. But usually households save and firms invest. Interest rates are the market price that coordinates the decisions of individual households and firms.

What is special about Austrian capital theory is that the investment--purchases of capital goods by firms, involves plans to produce consumer goods at various future dates. And what consumer goods and when determines what structure of capital goods are most profitable.

If instead, capital goods are all the same, and their capitalness is mostly their durability--they help produce consumer goods for an extended period of time--then it is much simpler.

Anyway, I suppose my view would appear to be some kind of sliced up version of capital theory and monetarism. It really comes closest to Wicksell. Check it out sometime.

[Dan]

Bill,

"It has been many years since I read Hayek's Pure Theory of Capital. I found it tough going."

I appreciate your honesty.

"You have a complete understanding?"

I can't say I have a complete understanding of anything. I think anybody who says he does is full of it. But maybe I have sufficiently enough of it to detect that you are completely way off.

"What I think is that you are confusing Austrian capital theory with Rothbard's interpretation of Mises' pure time preference theory of interest"

Bill, come on. You are rusty on capital theory but not on Rothbard's interpretation?

"The way Rothbard looks at it, there is money and then there are present goods and future goods."

That's just flat out wrong. That's actually compatible with Mises view of money as "neither". Rothbard maintained that money is a present good. An irrelevant note for this discussion.

And again, you're just presuming what I think and you're all wrong about what Rothbard. Maybe you should refresh your memory with a good read of MES because here it is again:

"This is the source of your argument that a shift from "investment goods" to money must be an increase in time preference and so the natural interest rate. That isn't capital theory. It is Rothbard's monetary theory."

So now I read the rest and it's one long straw man argument. So there is almost no point in responding to it all.

"Time preference involves the value of present vs. future consumption. A shift from bonds to money is not a shift from future consumption to present consumption."

And a shift from consumption goods to money? What does that do? I wonder what your response would be but save it,

I'll give it one more effort to explain it.

Your automatic assertions about what happens with respect to time preference are completely unwarranted and can be shown to be totally illogical:

If the proportion between present and future goods is $30 and $70, for a ration of 3/7. Now if people increase their cash holdings by $20 by refraining from spending only by cutting future goods, then you are left with $30 on consumer goods, $50 on future goods, and $20 in your pocket. And yes, $20 are real assets in the form of perfect liquidity; cash!
Now, this leaves you with a new proportion of spending between present and future goods; $30 and $50, for a ratio of 3/5.

Now, according to your own definition - holding money is refraining from any form of spending; consumption or investment (present or future). So, to claim, as you are trying to do that the proportion of spending between present and future is not changing, you basically have to make the amazing illogical claim that people are indeed refraining from spending those $20 but also at the same time don't refrain from spending those $20.

The only way for people to increase their cash holding by $20 without changing their time preference, that is without changing the proportion between present and future goods, is by cutting present goods by $6 and cutting future goods by $14. This leaves us with $24 of spending on consumption, and $56 on investment, for a ratio of 3/4, unchanged from before like you had requested it. And of course, let us not forget the $20 of assets in the form of perfect liquidity in my pocket.

That the above is correct can be demonstrated in another way, and this is where capital theory enters the scene. In the first scenario (a version of your own example) of people increasing their cash holding by $20 by strictly cutting their spending on investment goods, your ME/FB institutions will do what with the increase in $20 of cash holdings? Issue fiduciary media warranted by the previous increase of $20 of cash balances. That new media will enter the market in the form of loans. Assume those loans are made out to entrepreneurs investing in producers goods (as most of them are) for which wage earners in those capital industries receive the new money as wages. This means that instead of the $50 on investment and $30 on consumers, you have once again $70 of spending on investment goods and $30 on consumer goods. Now for this proportion as reestablished on the account of the banks responding to "demand to hold money" to be sustainable, ALL of the $20 of the new money/fiduciary media MUST BE HELD or SAVED by those who receive it, so that the 70-30 is maintained. If any part of that $20 is spend on consumer goods, the 70-30 established by the ME/FB will prove to have been unsustainable; intertemporal discoordination. Obviously, it is not reasonable to expect that such a condition could take place. At least some if not most of that money will be spent on consumers goods. Here is Hayek on this issue:

"[S]o long as any part of the additional income thus created is spent on consumer’s goods (i.e., unless all of it is saved),the prices of consumer’s goods must rise permanently in relation to those of various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods
of production that will appear profitable."
(Hayek, the pure theory of Capital)

[Rafael Hotz]

@ Woolsey "Most economists, including me, count money as an asset, so that accumulating money is saving. Using income to accumulating money, accumulate some financial asset, or even paying down debt are all different ways of saving. This is a flow. This flow of saving builds up net worth. Net worth is assets minus liabilities. It is a stock. Building up wealth now allows for increased future consumption. Dissaving is when you reduce net worth, and consume more than income. Reduced future net worth reduces future consumption. Time preference involves the value of present vs. future consumption. A shift from bonds to money is not a shift from future consumption to present consumption."

Suppose an investor keeps consuming the same proportion from his income and cuts investment expenditures, hoarding this money. This "money accumulation" does not represent net savings. This money represented net savings at t-1. If the banks create fiduciary media above it they are not adding to the REAL loanable funds supply. In order to have net savings, there must be reduced consumption at t0.

A shift from bonds to money is a shift from future to present consumption in a sense yes. Bonds represent prospective future money. The are future goods, ceteris paribus less valuable. A future bread can not saciate hunger as much as a present one. The subjective yield from holding present purchasing power is higher than holding a bond. There is an increase in time preference in a shift from bonds to money.

What is supposed to happen with the interest rate on the system (remember interest rate is not formed only on the loanable funds market, but in all time markets (stages of production), it's on Bawerk Capital And Interest)? The price of the goods of higher order bought by the investors (price of bonds down, less financing and expenditures for them) are going down RELATIVELY against consumption goods. Production should be reswitched to the short run via Hayekian mechanisms. The time preference is rising (as shown by the relative prices of higher order goods and consumption goods) and the real interest rate should go up! If you create fiduciary media this relative prices are distorted and the cycle triggered.

The main problem is the conflation of demand for deposits and demand for bonds (future goods). When you buy a current account from a bank you buy the service of transporting your PRESENT money at different LOCATIONS (via cheques, debit-cards, whatever). When you buy a savings account, or a liquid bond, you buy FUTURE money. That's a Huerta de Soto main point.

[Bill Woolsey]

Dan:

A shift from the demand for consumer goods to money is an increase in saving--an increase in the demand for future consumption. It is a shift from present consumption to future consumption.

You were incorrect about my definition. I have criticized the claim that an increase in the demand for money is a demand for nothing. It is an increase in the demand for something--money. Money is an asset. If income is used to accumulate money rather than consume, it is saving. It is a postponement of consumption. It is a demand for future consumption. (Paying down debts are the same.)

So, I would say that a increase in the demand for money entirely due to less spending on _other_ future goods leaves the balance between the demand for present and future goods exactly the same.

Your example where income is $100 and consumption is $30 and saving is $70 (which I can call "demand for future goods," if you like,) so that the saving rate is 70% of income (and the ratio of consumption to saving is 3/7,) then if there is an increase in the demand for money funded solely by reduced expenditure of income on other assets that might be accumulated (like bonds,) then the demand for future goods remains $70. It is now $50 of other assets accumulated and $20 of money rather than $70 of other assets and $0 of money. The savings rate is still 70%. The ratio of consumption to saving is still 3/7.

This entire step where you pull the money out and then say the remaining expenditure is 3/5 is mistaken.

As for your analysis of the producers goods you forgot that the demand for producers goods already fell when those accumulating more money purchased less of them. And then, when the banks created more money and lent it, the demand for producers goods increase the exact amount they had previously decreased. In other words, there is no change in the demand for producers goods. When the workers are paid to produce them, well, they were already being paid to produce them. The demand for the products and the labor used to produce them is unchanged. There was no increase in the money received by workers producing capital goods. There is no need to worry about whether they save all of that added money they earn or not.

There was no change in the demand for consumer goods either.

I have no confidence that you understand the context of the Hayek quote. I presume he was discussing an excess supply of money. He generally did.

[Dan]

Bill,

You're trying to win an argument over elementary economic logic by forcing definitions and "solutions" that match your version of the story. It won't work.

To cap, you are basically saying this:
When I stop spending $20 on investment goods by increasing my cash in may wallet, you are basically insisting that there is still a demand for those $20 of goods.

So let's see now. $70 is spent on hot-dogs. Previous customers cut back on their hot-dogs by $20 and hold on to their money, that is, they don't switch to hamburgers or something else. But along comes you Bill insisting that, no,no, there is still a demand for $70 of hot-dogs. No obfuscation of money is an asset or whatever is going to change this above ridiculous conclusion.

Now back to the real example at hand where you set me straight:

"In other words, there is no change in the demand for producers goods. When the workers are paid to produce them, well, they were already being paid to produce them. The demand for the products and the labor used to produce them is unchanged."

A simple question for you with respect to the above. Will the wage earners above spend some of that new $20 issued by the bank on consumers goods? yes or no?

If no, please elaborate...
If yes, then Bill, I'm sorry to inform you that your $20 of fiduciary media have just caused an intertemporal miscordination in the structure of production.

See Hayek above.

de Soto also talk about some of these same mistakes you are making right now in our exchange.
see http://mises.org/books/desoto.pdf
pp. 688 - THE THEORY OF “MONETARY EQUILIBRIUM” IN FREE BANKING RESTS ON AN EXCLUSIVELY ACROECONOMIC ANALYSIS

[Steve Horwitz]

Mr. Bird will not be flapping his wings or spreading his droppings in these parts anymore.

[Current]

Steve, Oh good.

Dan,

Part of the problem with this argument is the "psychic yield" or "hedge against uncertainty" properties of money. Now, as I said earlier that is what money is all about and that's the service that it gives to the holder.

However, that doesn't mean that a bank (and by extension society) can't also treat it like an asset. *You* may not know exactly for how long you'll hold a particular stock of money. Your bank on the other hand, can aggregate information over it's thousands of customers.

Look at it from the bankers perspective. He can say, I have $30million on deposit. I know that my depositors will trade about ~$2 million of that between this Monday and next monday. And, I know that by next monday I may have between $28million and $32 million in deposits. So, I can lend out ~$25million safely.

Now it doesn't matter that individual depositors may be uncertain about exactly when they are going to use their money. What matters is that on average the banker can make an assessment.

[Lee Kelly]

Dan,

Hayek frequently qualified his objections to credit expansion with the condition that the velocity of circulation not decrease proportionally. Here is what Hayek wrote in 1933 for the Encyclopedia of the Social Sciences:

-----quote-----
Unless the banks create additional credits for investment purposes to the same extent that the holders of deposits have ceased to use them for current expenditure, the effect of such saving is essentially the same as that of hoarding and has all the undesirable deflationary consequences attaching to the latter.
-----quote-----

In any case, if income is $100, saving is $70, and consumption is $30, then $0 is held as money. Another way of saying this is that $70 is spent on non-monetary assets, $30 is spent on consumer goods, and $0 is spent on money. That is, no non-monetary assets or consumer goods are foregone to hold money.

If one wishes to hold $10 of money, then $10 of non-monetary assets, consumer goods, or some combination of both must be sacrificed. Suppose that one foregoes $10 of consumption to spend $10 on holding money. Now savings is $70, consumption is $20, and money holdings is $10. The matter seems to concern whether the $10 of money holdings ought to be considered an addition to savings.

Whether the $10 of money holdings acts like an addition to savings depends on the particular kind of money one is holding. If the money is fiduciary media created by a fractional reserve bank, then banks can expand credit without increasing their risk of illiquidity. Presuming a 10% reserve ratio, then one's $10 of money holdings will finance $9 of investment spending.

So far as the allocation of resources is concerned, the consequence of increasing one's money balances by $10 is very similar to increasing one's savings by $10. Take a look at the follwing two examples:

Saving - $80
Consumption - $20
Money - $0

Saving - $70 (+9)
Consumption - $20
Money - $10

Total monetary spending is almost equal in each case, $100 and $99. The bank must keep some reserves to meet customer redemptions. People may prefer to hold $10 as money instead of savings because they need liquidity for unpredictable expenses. Since, on average, bank customers do not demand more than 10% at any time, the $1 difference in total monetary spending is expected to be spent on something.

The loss of $9-10 of income to sellers of consumer goods is offset by a gain of $9-10 of income to sellers of producer goods.

The allocation of spending between producer and consumer goods is almost equal (depending on whether that extra $1 is spent on saving or consumption). I cannot see how this process must necessarily bring about malinvestment, not unless reducing consumption to fund bond purchases does the same.

In the case that money is not fiduciary media issued by fractional reserve banks, but metallic money stored by 100% reserve banks, the situation is quite different. An increase in money holdings of $10 does reduce total monetary spending by that same amount. The loss of $10 income to sellers of consumer goods is not offset by a gain of $10 of income to sellers of producer goods. Resources cannot be reallocated toward investment projects until the price level falls, i.e. the real quantity of money increases.

It might be argued that this isn't a bad thing, because holding money isn't really a form of saving. However, a medium of exhange which is subject to such fluxuations in its exhange rate with other goods is frustrated in its role as a medium of exhange, i.e. it moves toward being a non-monetary asset. Good money, as Hayek noted, has a relatively stable (or at least predictable) price level.

[Bill Woolsey]

Hotz:

Suppose someone decides to increase to increase net worth by $100. Income was $50,000 and consumption was $50,000. But at t-1, they decide to save, and make consumption $49,900. Then, the next year, they go back to consuming $50,000. Saving is zero.

Now, that person could save buy purchasing a bond or by holding money.

In either case, in t0, they are not saving anything.

What has happened is that the supply of saving increased in t-1 and then fell again in t0. The natural interest rate would fall in t-1 and rise back in t0. This occurs regardless.

Anyway, the argument that bonds are claims for future goods and money isn't is false.

I hold money in order to spend it later. I hold bonds in order to spend it later.

To buy bonds I must spend less on consumer goods now (or some other asset.) To accumulate money I must spend less on consumer goods now (or some other asset.)

A "one shot" increase in the demand for money is a "one shot" increase in saving. (If this is funded by spending less on consumption out of income.)

I don't think the argument that interest rates are determined by the difference between the prices of inputs and outputs is exactly true. I don't even think that is what bom bawerk meant. But, I don't deny that interest would exist if all economic activity was financed by equity and that in the real world, where credit markets are large relative to equity financed production, interest shows up in the production process.

Anyway, as I explained already, if there is a shift from bonds to money, and banks supply money and make loans, the demand for capital goods are not changed. The derived demand for inputs is not increased. There is no tendency to bid the prices of those resources relative to the prices of their outputs.

If, on the other hand, the demand for consumer goods fell and the demand for money rose, and the banks issued new money and made loans, then sure enough, there is a closing of the gap between consumer goods and the resources used to produce them. The demand for the consumer goods falls. The demand for resources used to produce consumer goods don't fall because they are demanded to produce capital goods. And the prices of the capital goods rise with the demands for them. The natural interest rate has decreased.

[Bill Woolsey]

Dan:

I am using standard definitions. Saving, investment, net worth, etc.

Anyway, if the demand for hotdogs falls, and the demand for money rises, that isn't really a demand for hotdogs. It is a demand for money. But money isn't not spending. It is an asset. It adds to net worth. It allows increased consumption in the future when it is spent, like any other asset.

Anyway, if the banks supply more money by making loans, then the resources freed up from producing the now longer demanded hot dogs are now used to produce capital goods, which makes it possible to produce consumer goods in the future. There will be consumer goods there when then person holding the additional money wants to spend it.

You ask me a question that I already answered.

People demand less bonds and more money. The banks issue more money and lend it to firms that buy producers goods. The firms that would have sold the bonds purchase fewer producers goods. Spending on producers goods are unchanged. The demand for labor to produce these producers goods are unchanged. No doubt, the workers, working the same amount, earning the same amount and producing the same amount, will use some of their income (most of it) to purchase consumer goods.

You focus is to look at the new money only rather that looking at the pattern of demand.

By the way, it is not necessarily true that if there is deflation, that the real capital gains on money will all be spent in the initial division of expenditure between nonmonetary goods.

By way of analogy, increases in real income impact inferior goods, luxuries, and necessities in different ways. The real capital gains on money holdings would have a similar impact.

If you boil everything down to time preference defined by the ratio of expenditure on consumption and nonmonetary saving, and assume that must be constant through the adjustment process, you come up with something like the stories you are telling about deflation. But this is just a simplifying assumption.

I really think translating your analysis into conventional laguage--saving, investment, net worth, the capital stock, depreciation--would help. None of these arguments about capital, as far as I can tell, have anything to do with the Austrian insights about a structure of capital producing consumer goods and various future dates. Present vs. future goods? That is the simple now vs. the future. Consumption or saving. Consumer goods or capital goods. That is the way I usually think of things this way too. Simple is good when it does the job.

In my view, the reason Austrian capital theory comes into this is that if there is an excess supply of money, and this lowers interest rates and results in the production of more capital goods, if capital goods are homogeneous, then this is just more resources. If their is a complicated structure, the wrong capital goods have been produced. But "present vs. future goods" says nothing about it.

[Bill Woolsey]

Current and Lee:

There are two issues.

Do fractional reserve banks adjust the quantity of bank money to meet the demand to hold it?

And, if the quantity of money is expanded by banks in such a way that it just meets additional demand, does it create malinvestment?

The answers are separate.

[Rafael Hotz]

"What has happened is that the supply of saving increased in t-1 and then fell again in t0. The natural interest rate would fall in t-1 and rise back in t0. This occurs regardless."

Sure, if there is no new fiduciary media.

"Anyway, the argument that bonds are claims for future goods and money isn't is false."

Is or isn't? :)

"To buy bonds I must spend less on consumer goods now (or some other asset.) To accumulate money I must spend less on consumer goods now (or some other asset.)

A "one shot" increase in the demand for money is a "one shot" increase in saving. (If this is funded by spending less on consumption out of income.)"

In agreement. But if you increase your demand for money only by surrendering bonds there is no increase in savings. Here your savings at t-1 were could have been channeled through money or bonds, and you prefered bonds. Sometimes free bankers conflate demand for money and savings, IMHO.

"I don't think the argument that interest rates are determined by the difference between the prices of inputs and outputs is exactly true. I don't even think that is what bom bawerk meant."

Oh, yeah they are... "Present goods are, as a rule, worth more than future goods of like kind and number. This proposition is the kernel and centre of the interest theory which I have to present." (Bawerk's Positive Theory Book V Ch.1)... Loanable funds market help to adjust all this rates through money-prices calculation... If interest rates doesn't spring from time preference where does profits come from? Surplus value? Capital productivity?

Also on this Positive Theory's "The Capital Market in its full development".

"Anyway, as I explained already, if there is a shift from bonds to money, and banks supply mney and make loans, the demand for capital goods are not changed."

Oh yeah, it has changed. Why does someone issue a bond? Consume or invest, in some proportion. If the demand for bonds goes down, consumption or investment should be going down, at some PROPORTION. Ficuciary media issued is going to disrupt this proportion - and change input-output RELATIVE prices, triggering discoordination. This is Hayek's Prices and Production essence, IMHO.

"If, on the other hand, the demand for consumer goods fell and the demand for money rose, and the banks issued new money and made loans, then sure enough, there is a closing of the gap between consumer goods and the resources used to produce them. The demand for the consumer goods falls. The demand for resources used to produce consumer goods don't fall because they are demanded to produce capital goods. And the prices of the capital goods rise with the demands for them. The natural interest rate has decreased."

This process does not require fiduciary media above the new money hoards. Output prices fall relatively input prices and the production structure is lenghtened.

[Bill Woolsey]

Hotz:

The claim that bonds are claims to future goods and money is not a claim to future goods is false.

Both bonds and money are claims to future goods.

If there is a decrease in the demand for bonds and an increase in the demand for money, there is no increase in saving. Of course.

And there is no decrease in the money rate of interest. (The decrease in the demand for bonds is a decrease in the supply of credit exactly offsetting the increase in the supply of credit by banks.) There is no increase in the demand for producers goods. (The decrease in the demand for producers goods by the firms that would have sold the bonds is exactly offset by the increase in the demand for producers goods by the firms that borrowed money from the banks.)

Your "some proportion" assumption is uneconomic.

Why do people sell bonds? To fund investment and consumption in some proportion? True enough. Why do people borrow money from banks? To fund investment and consumption in some proportion. If the proportions are different, then they are different.

Anyway, the reason I say that the "some proportion" is uneconomic is that there are changes in prices--interest rates-- and these result in responses in demands for various sorts of goods. "Some proportion" shows a failure to appreciate market coordination.

As a rough rule of thumb, the decrease in the demand for bonds would raise interest rates. The higher interest rates would reduce the demands for a variety of goods depending on their interest elasticities. The increase in the supply of bank loans reduces interest rates. That would raise the demands for various goods depending on their interest elasticities. But it isn't that first one happens and then the other. It is that the decrease in the supply of credit due to a decrease in the demand for bonds is offset by an increase in the supply of credit by banks. The supply of credit is unchanged. Interest rates don't change. There is no change in the demands for goods.

Now, bonds and bank loans aren't really perfect substitutes. And so the interest rates on bonds will rise a bit and the interest rates on bank loans fall a bit. The effect on the "money rate" is ambiguous. There is almost certainly some change in demands. SO WHAT! Why is this malinvestment?

What if people buy one kind of bonds rather than another? What if they buy bonds from one industry rather than another. Surely this impacts the allocation of funding and resources. Why is it malinvestment?

Finally, I have never said that any process requires bank lending. What I have said is that if the quantity of money is expanded through loans in a way that exactly matches the increase in the demand for money, there is no malinvestment.

Whether or not this process has some advantages over a decrease in the prices of goods and services and so an increase in the real quantity of money sufficient to match the additional demand to hold money is a separate question.

[Current]

Rafael, remember Bill is talking about demand for money *to hold*.

Also, we don't need complex interest & capital theory to talk about this aspect of ABCT. An assumption of no productivity growth and interest caused only by time-preference will serve us fine.

[Rafael Hotz]

"Both bonds and money are claims to future goods."

Well, we disagree here.

"Your "some proportion" assumption is uneconomic.

Finally, I have never said that any process requires bank lending. What I have said is that if the quantity of money is expanded through loans in a way that exactly matches the increase in the demand for money, there is no malinvestment."

Another key disagreement. My proportions ARE the interest rate. Look Rothbard's MES Chap 17 when he criticizes Kaynes. Maybe I expressed myself bad. Time preferences express themselves through the demand for money via this proportions.

[Dan]

Bill

"Anyway, as I explained already, if there is a shift from bonds to money, and banks supply money and make loans, the demand for capital goods are not changed."

Yes, but I never complained about a fall in demand causing some problem. So this doesn't resolve the issue. You just haven't figured out [yet] what the issue is.
The demand for the capital goods doesn't change in our example, correct. But only because the banks have compensated for the decrease in demand of all those people who have cut their expenditures on those future goods and have increased their cash holdings instead. You think there is no problem with this. I say there is, big times! The action of those people who have increased their cash holdings have changed their preferences with respect to their proportional expenditures between future and present goods.(According to your example, of course) This change will be revealed when the new fiduciary media reaches the wage earners. The proportions you think were maintained by the bank compensating for the drop in demand will change the minute those wage earners spend that new money on consumers goods.

[Sleazy P Martini]

I must say, the free bankers seem to be on the
run, as if they're being hunted down like rats.

[Dan]

Lee Kelly,

You're taking Bill's example from the other direction; Increasing cash balance by cutting consumers goods. You're trying to avoid the complexity of when only spending on future goods are cut. Fine!

Continuing with your example:

Saving - $80
Consumption - $20
Money - $0

Saving - $70 (+9)
Consumption - $20
Money - $10

Forget the reserves. I don't care about it. Let's make it +10 (for simplicity) that the bank compensates for the drop of the $10 demand in consumer goods. So we have:

Saving - $70 (+10) = $80
Consumption - $20
Money - $10

Now, that $(+10) will reach wage earners. Here is the MILLION dollar question: What will they do with those $10? save it? or consume it?

We know that out of the total income of $100, $70 will be saved, and $20 will be consumed. This behavior of spending was defined by you as a given in the problem. But the +$10 is new money. It is yet to be established what its new owners will do with it. So Lee, I ask you again, what will they do with it?

I don't know either but I can tell you this: if all of that $10 is not saved, then your 80-20 cannot be sustained. The activity financed by it proves to have been a malinvestment. Go ahead, play with the numbers and see what ratios you get when that $10 is partially or totally consumed.

The above becomes abvious when you realize that without the action of fiduciary media, you would have had a proportion between future and present of 70-20 (7/2). With the fiduciary media, you have allegedly have 80-20 (4/1). What gives? There is a discrepancy in the time preference. The two are not equivalent.

Remember, ME/FB proponents don't deny that the market can adjust to (70-20) by price adjustments. They just claim it's a more painful transition.

[Lee Kelly]

Dan,

The $10 of new money may be squandered, but that would have nothing to do with fractional reserve banking and fiduciary media per se. The money had from selling a $10 bond could also be squandered. Doing away with fiduciary media does not eliminate the possibility of malinvestment.

The time preference is the same in both cases. I seperated monetary and non-monetary assets, but both are a form of saving, i.e. both are obtained by refraining from consumption. People hold money because they expect to spend it later, and people hold bonds because they plan to spend later. This doesn't mean that holding money or bonds does not also serve an immediate goal, but merely that the ultimate end of holding either is future consumption.

[Dan]

Then have the bank issue $20, or $30. Make it $100, and then just assert that the "new money may be squandered". What kind of a response is that?

You talk about micro-economic foundations, but in reality, you, as well as Bill, are thinking about the problem in aggregates.

I've made may case. Fiduciary media, in any amount, sets off the boom/bust cycle.

[Current]

Dan, Lee Kelly,

I think you are talking past each other in this last part.

Dan writes:
"Saving - $70 (+10) = $80
Consumption - $20
Money - $10

Now, that $(+10) will reach wage earners. Here is the MILLION dollar question: What will they do with those $10? save it? or consume it?"

So, in the earlier example we had $80 investment. In this example we still have $80 investment. Where is the big change? There isn't one.

As Lee says that $10 of investment could be wasted, but his point is that it could be wasted in either scenario. And, in both scenarios it will reach wage earners. As Lee says the time-preference shown here is the same.

[Dan]

current,

" As Lee says the time-preference shown here is the same."

Obviously not! Actors have cut their expenditures on future goods by $10. The $80 after the cut in expenditures was the result of $10 of new money created by the banks.

"As Lee says that $10 of investment could be wasted, but his point is that it could be wasted in either scenario. "

We are using the imaginary construct of the ERE for the analysis. The initial 80-20 is a state of equilibrium. There is no entrepreneurial squandering of money. Then we assume a change in conditions/preferences and analyze whether the issuing of new loans via fiduciary media, even in amount that's only in accordance with what ME theory prescribes, sets the structure of production on a sustainable path towards the new state of ERE/equilibrium compatible with the changes of conditions, or on an unsustainable path in accordance to ABCT.

[Bill Woolsey]

Dan:

Thank you for your discussion.

I think you have helped me understand that the error made by Rothbardians involves a failure to carefully distinguish between stocks and flows and temporary versus persistent changes.

The changes in the demand for money are assumed to be permanent changes in the demand for a stock. The division of the flow of income between saving and consumption is assumed constant, or else, if there is any change, it is assumed to be persistent.

[Current]

Dan, Bill,

I think the disconnect here is due to the role of money. We have all agreed about money's role as a hedge against uncertainty.

But, that's only money's role to the consumer. To the banker fiduciary is also simultaneously a liability.

In the discussion of the investment/consumption breakdown Dan doesn't include money with either investment or with consumption. Because when funds are held as money no positive choice between investment and consumption has been made. We put it in investment because we're also looking at the situation from the banker's side. To us it doesn't matter how the defferal of consumption has come about, holding fiduciary media is just as good as any other reason.

Part of the problem here is this simplistic business of treating money as a present good because it gives a service to the person holding it in the present. Now, that may be true but it doesn't stop money also being a future liability to a banker.

[Bill Woolsey]

Current:

I read your point in one of your earlier arguments. I think what you said about Hutt's approach of thinking about the liquidity yield on money may be helpful.

The principal amount of the money held is a future good. The liquidity yield is a present service. Of course, if we don't focus on hand-to-hand currency, with its zero nominal yield, and instead focus on checkable deposits, which can pay nominal interest, the distinction is less obvious. The liquidity services are just an aspect of the asset that makes it more attractive to hold.

I think the problem is different. Suppose someone earns $50 k per year, consumes $45k and saves $5k. He currently has a $100k portfolio of corporate bonds.

He decides that he wants to portfolio to be $110k next year. His normal $5k of saving would only raise it to $105k. So, he saves $10k, and consumes only 40k this year. His portfolio is now $110k. And he returns to saving $5k per year and consuming $45k per year.

This jump in the demand for corporate bonds during the one year results in a temporary decrease in the interest rate.

If you replace corporate bonds with checkable deposits, what is the difference?

Malinvestment occurs if firms respond to the temporary increase in saving as if it is permanent.

Most of this discussion had been a slightly more complicated scenario. Rather than saving changing, the allocation of saving between different assets changes. Suppose our individual continues to save $5k per year, and was purchasing $3k of stocks and $2k of bonds each year. His portfolio of bonds is 100k and he decides he wants it to be $105. Adding $2k per year will get there eventually, but he wants it now. And so, he buys no stock and instead buys $5k of bonds. Now that his bond holdings are $105k, he returns to his past practice of buying $3k of stock and $2k of bonds each year.

There is no change in the demand for present vs. future goods, however, if particular firms being funded by corporate bonds take this temporary increase in demand (from 2k to 5k) as permanent, would be making an error. Of course, firms taking the difficulty in marketing IPOs as permanent would also be making similar errors.)

Replace money with corporate bonds, and the situation is the same.

Dan, and maybe the economists he is reading, assumes that if there was a increase in the demand to hold money by $3k for one year, reducing the purchases of other assets (stocks in this case) then we must treat this as a decrease in the saving rate.

His definitions would say that $45k of income was used for consumer goods, $3k was saved (used to purchase stock) and $2k was used to accumulate money, which is neither saving nor consumption. The saving rate is 6% and the rate of money accumulation is 4%. During the one year that money is accumulated at a faster rate, so the usual $2k is accumulated as well as the extra $3k, the saving rate has fallen to zero percent. This is assumed to be permanent. There is no demand for future goods at all. Only consumer goods should be produced forever. If the banks increase the quantity of money and lend it out, and firms continue to buy and produce capital goods then this will be malinvestment.

But, of course, the example here was constructed so that after accumulating the extra money, the households return to purchasing $3k of stock. Treating the change as permanent would be a mistake.

[Current]

Bill, I see what you mean, and I agree.

[Dan]

"I think the problem is different. Suppose someone earns $50 k per year, consumes $45k and saves $5k. He currently has a $100k portfolio of corporate bonds."

Assuming that the $50K refers to nominal net-income, the above is impossible unless there is some other guy in the economy that is doing the exact opposite, and even that can only be temporarily.

You're entire imaginary construct of the capital structure of production is totally fallacious. I suggest that you hold your horses. See if you can stop talking about 'rates' all the time and try to imagine the structure in a stationary state.