Woolsey on Malinvestment and Monetary Equilibrium

Steven Horwitz

Over at Monetary Freedom, Bill Woolsey has a lengthy post responding to charges by some Austrians that maintaining monetary equilibrium by increasing the money supply to match increases in demand necessarily produces malinvestment and distortions in the capital structure.  Bill's been fighting this battle in the comments here and on the Mises blog and this is a very clear summary statement of his views.  I think he's right on target here and I encourage the critics of MET to read Bill's post.  I will make only two comments:

1.  Bill's analysis is thoroughly grounded in basic economics, including standard finance and money and banking.  His use of terms is totally standard and there's nothing I can see that is in contradiction with how Austrians generally understand these issues.

2. His post also serves as a reply to the claim that MET is "macroeconomic thinking."  Notice that his argument is grounded in the microeconomic behavior of firms, households, and financial institutions and how they respond to changes in prices (in this case interest rates) and how their own shifting preferences initiate those changes.  I find the charge of "macroeconomic thinking" especially annoying given the title and major themes of my own book (Microfoundations and Macroeconomics:  An Austrian Perspective) and because in that section of Huerta de Soto's book my book is not addressed at all. 

Comments

[Richard Ebeling]

Part of the problem, unfortunately, is that Ludwig von Mises is ambiguous at times about what is an act of savings.

Clearly, savings can occur in several forms, one of which is holding an average cash balance of a particular size. And, clearly, to the extent that an individual holds a cash balance for potential future exchanges he is deferring consumption (a current demand for "present goods"). And, thus, resources that could have been demanded for use for the production of final "lower order" goods are 'set free" for alternative employments.

I apologize for not having the time right now to offer the specific "chapter and version," but in certain places in Mises' writings it is clear that cash balance holding IS an act of saving, and therefore deferred consumption that releases resources (including labor) for "higher order" investment goods production.

In other places, he claims that money left unused in demand deposits (as opposed to some form of more traditional savings account) is not an act of saving, but rather merely a desire to "park" some money for a while between consumption purchases. Hence, a bank extending loans on the basis of these demand deposit balances would be "destabilizing" in the business cycle sense.

But one can argue, it seems to me, that whether in the form of the demand deposit or actual "bank note" holdings, both are a deferring of consumption for a period of time, therefore, a "savings" choice.

If the banks (in the free banking institutional setting) make an estimate of the average turnover rate of their customer/depositors in terms of withdrawals from their checking accounts, or the reflux of notes and/or checks through the clearing mechanism, and balance this with lending to others, "synchronization" of savings and investment is, in principle, maintained.

Furthermore, precisely in the free banking setting, any errors or miscalculations are "discovered" relatively quickly as any such bank(s) find themselves suffering an unanticipated draining of reserves. And they would have the necessary and frequent "feedback" to marginally adjust their investment lending (or relending as previous loans are being paid off) to reasonably match this with changes in peoples' demand for money (average cash balance holdings) in the form, again, of either actual "bank notes" or checking deposit balances.

Now, obviously, this private, free banking institutional arrangement could (would?) maintain (unintendedly) what the economist may call a "monetary equilibrium" between the demand for and supply of money.

But let us not overlook that this is merely one meaning of "monetary equilibrium," i.e., a relatively stable purchasing power of the money unit, free from any significant fluctuations from the "demand for money-side."

However, let us not forget that normally we talk about equilibrium, in general, in terms of a price or set of prices (when referring to a number of goods at the same time) that brings about a "clearing" or "balance" between supply and demand in and between markets.

If we say that the demand for product "x" has increased, we do not say that to maintain equilibrium, supply has to increase sufficiently to preserve the same price that prevailed in the market before the change in demand. Rather, price is expected to change to "balance" the two sides of the market, given the shapes and relevant positions of the demand and supply curves.

Given an increase in the demand for money (a desire to hold, on average, a larger cash balance), monetary equilibrium can also be reestablished through the appropriate adjustments (downwards) in the money prices of goods in the market, which satisfies the greater demand to hold through a rise in the purchasing power of the monetary unit (a lower "price level").

One is choosing for analysis and possibly for policy purposes to define monetary equilibrium in one particular way, which is different from how we mean "equilibrium" in terms of supply, demand and price in many, if not most, other settings.

Richard Ebeling

[Current]

It seems to me that in the term "Monetary Equilibrium" the word equilibrium is used in the Marshallian sense - a situation that has continued for a long time.

[Lee Kelly]

"If we say that the demand for product "x" has increased, we do not say that to maintain equilibrium, supply has to increase sufficiently to preserve the same price that prevailed in the market before the change in demand." - Richard Ebeling

While true of most goods, it is also why most goods do not make good money. Good money has relatively stable supply *and* demand compared to other goods. Fiduciary media created by fractional reserve banks allows for extremely an flexible money supply. Clearly, this is dangerous in the context of a monetary monopolist and central bank, but given the right institutional checks and balances, fiduciary media allows the market to adjust much faster than commodity money.

[Bill Stepp]

Bill Woolsey's post is good, and his logical step-by-step method no doubt serves his students well.
Let me add a footnote and clear up what I think is a minor confusion. If someone decreases his consumption and invests his additional savings into corporate bonds, his time preference falls, just as bond yields (and interest rates) decline, ceteris paribus. However, before he buys the bonds, it's possible that his demand for money increases, for example, if the money he would have spent on consumption is in a non-interest bearing account. Since money is a present good (Rothbard called money a present good "par excellance" in Man, Economy, and State--I think that's it), his time preference stays the same even though his consumption declines. Time preference equals the demand for present goods divided by the demand for future goods. The demand for present goods equals the demand for consumption goods plus the demand for money. The demand for future goods equals the demand for investment goods (or services, as Rothbard might have said), including investments. Investments include an array of stuff, from plant and equipment to stocks, bonds, derivatives, etc. It's all services in the end.
Trading one asset for another can involve a change in time preference, such as when someone chooses to sell a bond and hold the proceeds in cash (increasing his demand for money), or vice versa. Swapping a bond for a stock involves no change in TP. I recommend that Bill Woolsey incorporate this into his classroom teaching and writing, and that Austrians adhere to this (Rothbardian?) point, as I'm sure most do.

[Dan]

Steve,

Are you suggesting that a title of a book refutes all charges against you?

But anyway, I'm about to start reading your book.

[Steve Horwitz]

Of course not Dan. I am suggesting that the title indicates that it probably should be dealt with in the course of a discussion of the absence of microfoundations for MET.

[Steve Horwitz]

Richard,

Monetary equilibrium theorists would completely agree with your point about there being two ways to "skin the disequilibrium cat."

When we talk about goods and services, we assume that the adjustment to changes in demand will take place first through an adjustment in price (in the short run anyway), and that such adjustments are desirable. Supply might adjust in the long run.

It's different with money. If money demand rises, we can supply more real balances either through an increase in the nominal supply or through a fall in the price level with the supply constant. Either solution will get us back to monetary equilibrium.

The argument of MET folks is that relying on the price level to do the work is extremely costly in terms of its macroeconomic effects. That's the argument about price not adjusting perfectly and instantaneously. During that adjustment process, we get the recession.

This is Yeager's point about money having no price of its own to adjust. When money supply and demand are out of equilibrium, the adjustments must come from ALL prices and that process is socially costly. Precisely because money is the opposite side of exchanges from goods and services so it is that the proper adjustment mechanism in disequilibrium is the "opposite" one from goods and services: quantity instead of price.

Bill's post is one of the clearest explanations I've ever read of why adjusting through a change in the nominal money supply does not create the costs that some say it does.

What I don't understand is why people who think monetary disequilibria should just be adjusted out by changes in the price level (not saying this is you Richard) care so much about inflation. If money gets into excess supply, just let prices rise and we'll eventually get back to the old real money supply and be fine. If it works for a decline in the price level, why not a rise?

[Dan]

Because in the first, the cash induced changes reflect real changes in individual preferences with respect to demand to hold cash and spending.

In the latter, there will be intertermporal discoordinations that will always result from new money entering the system in the form of loans. Why this will happen regardless of the rule applied; price stability or ME, I have tried to make the case for in the other thread in the exchanges with bill and Lee: http://www.coordinationproblem.org/2010/05/reply-to-salernos-four-propositions-on-mises-and-the-free-banking-school.html?cid=6a00d83451eb0069e2013481779402970c#comment-6a00d83451eb0069e2013481779402970c

However, as I've said, I want to go over your book also.

[Rafael Hotz]

"Suppose that the households increase saving by reducing consumption expenditures out of income, exactly as before, but instead of spending the money on corporate bonds, they instead increase their money balances. The effects on those from whom the households would have purchased the consumer goods are the same. They sell less and earn less. The hire less labor and use fewer other resources. The incomes earned by those workers and other resource owners fall.

Assume that the banks expand their lending at this same time, and lend out newly created money exactly equal to the amount of money the households have accumulated. The quantity of money expands exactly the same amount as the demand to hold money."

What happens when there is a decrease in consumption in conjunction with an increase in hoardings? There is a tendency for the prices of consumer goods to decline. This will prompt economic losses for the entrepreneurs who did not forsee the change. This will also bring about a lenghtening of the productive structure. Why? Because there has in fact been a fall in time preferences. The interest rates at the late stages of production are going to fall. This will make some investments at the early stages economically feasible. And there is a tendency for the loanable funds market rate to fall. Why? Entrepreneurs suffering economic losses at the late stages will start loaning their money, buying bonds, stocks, whatever, because yields over there are still higher. At the end, there is a tendency for interest rates everywhere to fall. A tendency triggered by "real" factors.

If the banks issue more means of payment, what is supposed to happen? The loanable funds market interest rate is going to fall more than it was supposed to fall. Entrepreneurs at the late stages can keep their former business rolling over some debt and facing some economic losses. There can be investments at the early stages being launched without investments at the late stages being liquidated. But, we must always remember, we live in a world of scarcity. More means of payment have not created the real stuff used at these investments. Entrepreneurs at the new early stages compete with the scarce factors with the entrepreneurs at the late stages, using this new means of payment issued by the fractional reserve banks. And we clearly see that we have the cycle triggered. The factors spend their new (high) money income, but there haven't been any more savings. The fiduciary media just offset the increase in savings made previously. The rest of the history we know: generalized accounting profits, capital squandering, declining supply of present goods and price inflation, until the crisis.

At the opposite situation, without reduction in consumption and with a rise in hoardings, the inverse mechanism was supposed to raise interest rates and shorten the production structure. There has been a rise in time preferences here, even if there was no reduction in savings. A shift in demand from future money towards present money corroborates that. Those are not the same thing, although both represent prospective spending. Future money can't be used in the present (without a conversion with a discount). Time preferences get expressed at the consumption/investment expenditure ratios, not at the consumption/savings one. And here this ratio has been tilted in favor of consumption, as at the last example it has been tilted towards investment.

We can figure out a matrix with six scenarios concerning liquidity preference and time preference.

At the first scenario above, we have an increase in liquidity preference and also an decrease in time preference. It is if the agents are saying: "Hey, future is kinda foggier, but we can keep our future prospects if we sacrifice a little bit our pleasure now."

At the second scenario above, we have an increase in liquidity preference and an increase in time preference. It as is if the agents are saying: "Hey, future is kinda foggier, better have even more goods available. Speed up production, forget about more quantity and quality later".

There also could be an increase in liquidity preference without a change in time preference - consumption and investment expenditures would be cut at the same proportion. I could set up the remaining scenarios. The main point is: time preferences are expressed concommitantly liquidity preferences. The Keynesian agent who first expresses one, then the other is fallacious. Hoards and both kinds of expenditure are decided at the same time.

The conclusion is that the fractional reserve banks can try to offset changes at liquidity preference issuing more means of payment. But they will end up discoordinating time preferences meanwhile, triggering a cycle.

[Oderus Urungus]

Steve writes:

"The argument of MET folks is that relying on the price level to do the work is extremely costly in terms of its macroeconomic effects."

Can you please explain what you mean by a
"costly macroeconomic effect," and how it is
consistent with an emphasis on microeconomic
foundations?

[newfirst]

Like every other economic good, money is scarce. However, it is not necessarily obvious how the actions of individuals interact with the limited supply of money.

First of all, when someone makes a purchase of a good with money, this does not stress the supply of money because all that happens is that the money involved in the purchase is instantaneously transferred from the buyer to the seller, with no net effect in the total supply of money.

Rather the stress on the supply of money associated with money purchases comes from the pre-purchase holding period for the money accumulated for the purchase. In particular,the stress depends on the multiplicative product of the purchase price and the time duration of the pre-purchase money holding period.

This has all kinds of consequences, but the most significant may be that the demand for holding money is highly variable, if not arbitrary.

For example, let's say you have a monthly salary that serves in part to pay a monthly rent of $1000. It should be clear that the holding period of the $1000, and thus the resultant stress on the supply of money, can easily vary by more than an order of magnitude as the relative timings of the salary payment and the rent payment vary. This, of course, is only one of the many ways that large changes in the demand for holding money can result from what are otherwise innocuous differences in context.

Proposed lesson : Even if the demand for money could be accurately measured, using it as an input to an economic policy would seem to be sheerest folly.

This is not even taking into account that the demand for holding money by an individual is not homogeneous, but consists of at least three distinct components, each of which has distinct economic effects.

Regards, Don

[Bill Woolsey]

Hotz:

I always carefully take scarcity into account.

The orthodox (nonRothbardian) definitions of saving and investment do not require that first time preference is determined and then liquidity preference is determined. But you can call money a present good, a future good, or neither, and it tells you nothing about actual market processes.

I think that your problem is that you first think about how the economy would return to equilibrium if the demand for money rose with a fixed quantity of money. Then, from that equilibrium, you think about who an increase in the quantity of money would disturb it. The thought experiment is that the two things happen together.

Please, don't lecture me about paying attention to scarcity. You must be kidding.

Dan:

The allocation of income between consumption and saving by the accumulation of nonmonetary assets does not necessarily reflect what allocation of demand that will exist in equilibrium.

To give an obvious example, suppose people are saving 5% of income by purchasing bonds. They switch to accumulating money. Of that part of income not used to accumulate money, 100% is used for consumer goods. You rassumption is that this shows people put no value on future consumption and the all of current output should be used to produce consumer goods. And that if, instead, some capital goods continue to be produced, it must be the case that there will be shortages of consumer goods.

While a careful reading of my analysis will show that no such shortages will appear, I also think it is complete nonsense that people in fact do prefer to consume 100% of income in that scenario. I think the most likely scenario is that once people have accumulated the amount of money they desire, they will return to purchasing bonds with 5% of their income. Of course, saving rates could change. But the notion that accumulating money now with all income not consumed means that people really want to consume all of their income seems absurd to me.

[Bill Woolsey]

Steve:

Thank you for your kind remarks.

Richard:

I agree with Steve's response to you, but I would add that Yeager's term "monetary disequilibrium" may give a better picture of the approach. What is the process by which a the real supply of money adjust to the demand to hold money under alternative monetary institutions? The higher purchasing power of a given quantity of money is one possibility that gets covered.

Also, the policy approach can be described in "micro" terms. The higher the elasticity of the supply of the quantity of money the better. Of course, to say this suggests that having an elastic demand would work just as well.

[Nikolaj]

Woolsey: "thinking about what happens when there is an increase in the quantity of money given an unchanged demand for money, supply of saving, and demand for investment is highly misleading in a situation where the demand for money and the supply of savings are both rising and the demand for investment is falling."

So, the situation of "hoarding" is by definition characterized by the increased saving, as well as increased demand for money. How do we know that? All we do know when people increase their cash balances is that they reduced their overall expenditure that way, investment and/or spending. But, the whole point is that we don't know the precise proportions: whether they really increased saving (while reducing spending) or maybe reduced them both by an equal amount leaving the time preference when it was, or maybe reduced the saving more than spending, actually increasing the social rate of time preference, that would require a contraction of credit from the banks, rather than the expansion.

Sorry to say, but it seems we are still at the Swuare one.

[Nikolaj]

Here is one more silly Rothbardian who did not see the Keynesian light, namely discovered a subtle difference between the "effective demand" and "quantity of money", and who thinks that money is never "idle", and serves always its purpose no matter whether it is invested, spent or "hoarded":

"It is unsound to distinguish between circulating and idle money. It is no less faulty to distinguish between circulating money and hoarded money. What is called hoarding is a height of cash holding which—according to the personal opinion of an observer— exceeds what is deemed normal and adequate. However, hoarding is cash
holding. Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal. He who hoards money believes that some special conditions make it expedient to accumulate
a cash holding which exceeds the amount he himself would keep under different conditions, or other people keep, or an economist censuring his
action considers appropriate."

[Steve Horwitz]

"Can you please explain what you mean by a
"costly macroeconomic effect," and how it is
consistent with an emphasis on microeconomic
foundations?"

By "macroeconomic effects" I mean economy-wide, systemic problems such as unemployment, idle capital, negative rates of growth, etc.. All the signs we would associate with a recession. How those macroeconomic effects *come about* is through a whole variety of microeconomic processes involving the way the insufficient supply of money affects the decision-making of households, firms, and financial intermediaries.

My book starts with Garrison's quip about there being "macroecomic questions but only microeconomic answers." So in answer to the "macroeconomic questions" of "why are unemployment and business failures so high, and why is growth so low/negative?" we can answer by explaining what happens at the microeconomic level, in particular with respect to the effect of prices on economic calculation, as a result of the monetary disequilibrium.

BTW, isn't the Austrian cycle theory story the same kind of explanation? It explains observed macroeconmic effects, the economy-wide manifestations of the boom and bust, by reference to microeconomic processes triggered by inflation and its effects on interest rates and prices more generally.

For those who haven't read my book, what I'm outlining here is the core argument there: we can explain the systemic ("macroeconomic") effects of excesses AND deficiencies in the money supply by reference to how they affect the microeconomic coordination process as described by Austrians. I *explicitly* argue that we can't understand these things in conventional macro terms such a C+I+G and that even as much as MV=PY helps as an organizing framework for the effects of money, it by itself cannot account for the microeconomic processes at work.

This is why Bill's post is so helpful: he's explaining the microeconomic adjustment process taking place in response to an increase in the demand for money unmatched by an increase in the supply.

[Nikolaj]

Steve: "By "macroeconomic effects" I mean economy-wide, systemic problems such as unemployment, idle capital, negative rates of growth, etc.. All the signs we would associate with a recession. How those macroeconomic effects *come about* is through a whole variety of microeconomic processes involving the way the insufficient supply of money affects the decision-making of households, firms, and financial intermediaries."

So: 1) Recession is brought about by an "insufficient suplpy of money" among other things. Really "Misesian". :)

2) "Idle capital" as a "problem"
Here is what another silly Rothbardian from Vienna has to say about the "idle capital" as a "problem":

"The existence of unused capacity is...by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which (in consequence of “misdirections of capital”) the necessary durable equipment is available...The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes".

[Oderus Urungus]

But I thought the point of theories like
ABCT was not so much to explain macroeconomic
effcts as such, but rather to highlight the
particulars of economic phenomena (eg the
capital lengthening and shortening
characteristic of boom-bust cycles) that
macro aggregation necessarily obscures or
even ignores? Your answer sounds a bit like
wanting to have ones cake and eat it too (ie,
speak the language of mainstream macroeconomic
theorists while appealing to Austrian concepts).

[Nikolaj]

Steve: "What I don't understand is why people who think monetary disequilibria should just be adjusted out by changes in the price level (not saying this is you Richard) care so much about inflation. If money gets into excess supply, just let prices rise and we'll eventually get back to the old real money supply and be fine. If it works for a decline in the price level, why not a rise?"

Let me help you understand this, by quoting both of these silly Rothbardians from Vienna:

Silly Rothbardian 1: "It has been pointed out already in what respect we are free to call an improvement in the quality and an increase in the quantity of products economic progress. If we apply this yardstick to the various phases of the cyclical fluctuations of business, we must call the boom retrogression and the depression progress. The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment. The depression, on the other hand, is the way back to a state of affairs in which all factors of production are employed for the best possible satisfaction of the most urgent needs of the consumers"

Silly Rothbardian 2: "In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits."

[Steve Horwitz]

"But I thought the point of theories like
ABCT was not so much to explain macroeconomic
effcts as such, but rather to highlight the
particulars of economic phenomena (eg the
capital lengthening and shortening
characteristic of boom-bust cycles) that
macro aggregation necessarily obscures or
even ignores? Your answer sounds a bit like
wanting to have ones cake and eat it too (ie,
speak the language of mainstream macroeconomic
theorists while appealing to Austrian concepts)."

I thought the point of Austrian economics was to explain observed economic phenomena better than other approaches do. In fact, this is where ABCT came from: Mises and Hayek (and others) being familiar with the observed empirical data of 19th and early 20th century cycles and believing they had a better explanation for those "macroeconomic phenomena" than did other theories of the time.

Your point above makes it seem like AE is trying to explain something different from what other theories are trying to explain. I don't think that's true. What IS true is that AE lets us SEE causal elements of observed empirical phenomena that other theories don't - hence the Austrian emphasis on capital structure (which is central in my book, btw).

That is indeed "highlighting" elements others overlook. But that highlighting serves the ultimate goal of explaining the observed "macroeconomic" outcomes that all economists are interested in: why do economies go through periodic boom/bust cycles? Why is unemployment so high? Why do we see the cluster of errors?

Does that help to clarify?

If you want to call that "having your cake and eating it too" that's fine. It's what Mises and Hayek and most other Austrians have always done: try to provide better answers than other approaches do to the questions and puzzles that the economics professions is interested in. I don't see the sin in "speaking the language" of mainstream economics if by that one means trying to answer the broad questions that economics has long been interested in.

[Richard Ebeling]

Steve:

I, in principle, have no problem with the mechanism by which it is likely that private banks (in a free banking system) might very well adjust their outstanding liabilities relative to their reserves with a change in the demand for money (in the way that Bill very clearly explained in great detail, or that you have argued for, and which my earlier comment, surely, showed I agree with).

But let us recall that if this were to play out in this manner in a truly free banking environment it would be an unintended consequence. There is no reason to think that a particular profit-maximizing bank would see any purpose to make this a goal of its financial activities.

And there is no reason to think that an association of private banks would see this as its joint, or group-bank, task. Or we are, then, back to a centralized monetary regime of some type -- if there were to be cartel enforcement mechanism -- and, thus, then we are back to a form of central banking.

In a free banking environment there is no monetary equilibrium "target" or "goal" because there is no monetary policy. Banking and the interactive outcomes of money-demand and money-supply are merely the results of market processes, with no "right" or "wrong" about what the purchasing power of money might or "should" be.

Money may be a special or unique commodity on the market because, as many have correctly emphasized, it the good that is on one side of every exchange, and, indeed, the good that connects and binds all economic transactions into one interdependent market order permitting the method of economic calculation.

But in that truly free market, free banking social order, adaptations to changes in peoples' demands for money may be partly met through increases in money substitutes (fiduciary media) and through changes in the relative structure of prices that cumulative generates shifts in the scale of prices (the general purchasing power of the monetary unit.)

So in a free market, free banking world, any "difficulties" or "time-delays" in appropriate changes in various prices to reflect changes in the demand for money will become non-political dinner conversation, or class room examples in economics courses, or the study of economic historians.

Richard Ebeling

[Lee Kelly]

Nikolaj,

If income is $1000 and consumption is $800, then saving is $200. This is a tautology given the conventional use of these terms. That is, income is the sum of saving and consumption. If cash balances equal $100 (currency + checking accounts), then $100 of income is spent on cash balances. That is, no portion of income is unspent, because cash not yet spent is income spent on cash.

It seems to me your objection is that an increase in cash balances by $100 is not equivalent to an increase in bond purchases by $100. In your view, bond purchases unambiguously represent one's time preference, while an increase in cash balances does not.

I agree with you that an increase in cash balances of $100 is not equivalent to an increase in bond purchases by $100. Reserve ratios will prevent a credit expansion of $100 and savers will receive less interest. A shift from bonds to cash should slightly contract the supply of loanable funds. I also agree that the *long run* time preference of an increase in cash balances is less clear than an increase in bond purchases. But this just creates an incentive for banks to hold reserves and purchase more liquid assets to satisfy unpredictable changes. I believe this sufficiently compensates for the problem you identify.

[Bill Woolsey]

Nicolaj:

I have never said that an increase in the demand for money is a bad thing. Nor do I try to distinguish between money needed to fund transactions and other money that could be hoarded.

I would appreciate proper citations rather than "Silly Rothbardian." I found the statement about producers credit expansion in response to an overcontraction of the structure of production odd. My discussion is about a decrease in the demand for consumer goods, a decrease in the demand for investment, and an increase in the demand to hold money all at once. To me, the quote was suggesting an excess increase in the demand for consumer goods, and excessive decrease in the demand for capital goods, and nothing at all about the demand for money. It seemed the analysis was about an excess supply of money that is directly to business loans might be helpful, but it might create possible problems.

As I have argued before, assuming that the relative prices, including the real interest rates, that apply during unsettled times as being permanent, is foolhardy.

Lee:

I was not trying to explain how the banking system responds to changes in the demand to hold money. I am rather saying that if the banking system expands the quantity of money by making loans in a way that matches increases in the demand to hold money, then this has the same consequence as if financial assets had been purchased by the households. Any changes in the structure of production, i.e. the allocation of resources between the production of consumer and capital goods would be the same.

I haven't argued that free banks would actually do this. There are market processes that tend to have that effect. But even if there was no market process that had that effect, it would still be true.

I have not argued that the result is the exact same as what would happen if the price level falls and the real quantity of money rises to meet the demand. I don't think the Rothbardian analysis given by the various amateurs here has come close to explaining the market process. But I don't think that there is anything wrong with the allocation of resources that occurs through that process.

Richard:

From a doctrinaire libertarian perspective, perhaps we could just debate freedom of contract vs. fractional reserve banking as fraud. That would determine "policy" and then we monetary economists could talk about the consequences of the policy as matters of theoretical interest. Freedom of contract leads to malinvestment by banks. Well, its a tough world, we just must live with periodic malinvestments and their liquidation. Changes in the demand for money given a stock of money strictly tied to gold leads to general gluts of goods only gradually corrected by adjustments in the purchasing power of gold. While an elastic supply of bank money might greatly mitigate this, that would be fraud because reason tells us that two people can't own the same gold.

From a consequentialist perspective, however, this is a live issue. Is getting rid of restrictions on small note issue, option clauses, and reserve holding a good thing? Or is it a bad thing? Is imposing draconian reserve requirements a good thing?

And of course, we aren't on a gold standard. What is the best way to reform the current monetary order? That is a "centralized" decision. Institutional frameworks where the profit maximizing activity of banks actually issuing money create an more elastic supply of money are better, other things being equal.

[Lee Kelly]

Bill,

I didn't mean to disagree with you. I was just trying to address some of Nikolaj's concerns. I agree with your post at Monetary Freedom.

[Richard Ebeling]

Bill:

First, I do not consider fractional reserve to be fraud under a free banking regime.

Second, I wonder how often we would have a serious problem of significant fluctuations in the demand for money in a free banking, free market setting. There may be certain secular trends (increases in population, greater differentiation among the stages of production that increases the number of transactions in the exchange processes leading to final consumption, for example -- all of which were discussed in detail under "justified" increases in the quantity of money by Austrian economists in the 1930s, including and especially Gottfried Haberler in a lengthy monograph that he prepared for the League of Nations in 1931 and Fritz Machlup, among others).

And Milton Friedman, in his "Program for Monetary Reform," pointed out in an aside that under the gold standard any increases in the demand for money would generate the market incentives for gold prospecting, mining, and minting that would "counter-balance" the trend in the demand for money.

Now, under a central banking regime it can certainly be argued that the central bank's policy goal should be to manage the money supply to only (or primarily) adjust the supply of money to match changes in the demand for money.

But as Milton Friedman also argued in his presidential address at the Western Economic Association in 1985 (and published in the "Western Economic Journal" in early 1986), that public choice theory had convinced him that it will never be in the long-run interest of central bankers and those who "influence" the central banking system ever to follow a "monetary rule" of any sort.

This is why, also in 1986, Friedman stated that while he was not calling for the abolition of the Fed, he had concluded that, all things considered, it would have been better if the Fed had never been established and the U.S. had remained on a non-central bank gold standard -- in terms of the "costs" of a gold standard relative to the "costs" that fiat money inflation had generated for the society over the decades.

So . . . all I am saying is that if we ever were to be "advanced" and "enlightened" enough to end our system of monetary central planning and privatize all banking into a competitive free banking system, one consequence of this would be the end of monetary policy, since government would no longer be responsible or have the power to directly influence or control the supply of money.

Thus, changes in the demand for money might be partly met by changes in the supply of money through private banks deciding what their optimal reserve ratios on deposits and "bank notes" profitably might be, and some of the required adjustment might occur through changes in the general value of money (the "price level").

What would be the purpose or substance of private, competitive free banking if the government still had the authority to tell these private banks how to manage their outstanding liabilities relative to their reserves? And how would we escape, then, from a whole variety of "problems" that confront us now?

Richard Ebeling

[Lee Kelly]

"I wonder how often we would have a serious problem of significant fluctuations in the demand for money in a free banking, free market setting." - Richard Ebeling

I also wonder about this. Policies that decrease the relative risk of holding cash (currency and checking accounts) will exacerbate fluxuations in money demand.

For example, the risk of holding cash should change with the risk of the issuing bank becoming insolvent. In other words, an economy wide increase in perceived risk should be transmitted to cash balances via banks' balance sheets. However, the government has repeatedly stepped in and socialised this risk; those who reap the benefits of cash balances are not bearing the full cost.

It seems to me there are numerous other ways in which governments may be creating a more volatile money demand. I would be curious to see any thoughts by commenters here on the matter.

[Don Lloyd]

Richard,

"...There may be certain secular trends (increases in population, greater differentiation among the stages of production that increases the number of transactions in the exchange processes leading to final consumption, for example -- all of which were discussed in detail under "justified" increases in the quantity of money by Austrian economists in the 1930s, including and especially Gottfried Haberler in a lengthy monograph that he prepared for the League of Nations in 1931 and Fritz Machlup, among others)...."

I don't know about the 1930's, but in the modern world there would seem to be little significance for firms having increased production transactions as far as its effect on the demand for holding the medium of exchange. It is likely to be rare for a firm to need to hold actual money as opposed to something that can be easily converted into money within hours or days. Certainly any transaction which is invoiced has little or no need for a significant holding period of a medium of exchange, and the transaction itself neither creates nor destroys the supply of the medium of exchange, but merely transfers its ownership.

Regards, Don

[Bill Woolsey]

Richard:

Your posts always have a scholarly gem.

I know you don't take the view that fractional reserve banking is fraud and are more or less persuaded by Selgin's theory of how the quantity of bank money will adjust to meet changes in demand. Or, at least, when I read your agreements, you hedge just a bit. As I do.

Given the status quo where banking is based upon redeemability into a fiat currency subject to discretionary control, any shift to an alternative is going to be a matter of centralized decision making. Today, I do not favor having the Fed try to mimic the performance of a gold standard. But if we consider institutional reform, a switch to a gold standard would be a centralized decision. An alternative would be switch to a silver standard. Which would be better?

I do have one quibble with the notion that any adjustment of the total quantity of money to the demand for money is entirely a matter of unintended consequences in a free banking system. If you think about entrepreneurship in banking, in particular, speculation in interest rates, what other banks are doing, the current level of interest rates, and current economic conditions are going to impact the profit maximizing behavior of individual banks.

Think about Selgin's process. Nominal expenditure is growing slowly. While this could have a number of causes, one possibility is that the quantity of bank money is growing more slowly than the demand to hold it. If that is true, banks will see their supply of reserves grow more quickly than the demand for them. They will respond to that by expanding lending and lowing interest rates. An individual bank that forecasts this can purchase securities now and earn capital gains when interest rates fall. If all banks do this, they all purchase securities, interest rates do fall, lending does expand, and the excess demand for money doesn't occur at all.

OF course, they may make errors.

Your argument would be similar to a ipod manufacturer passively responding to the volume of sales, and then making price adjustments based upon that and resource prices. Most entrepreneurs, I think, keep close tabs on what the other firms are doing, overall industry conditions, and things that will effect industry conditions.

Of course, I don't want to hide that I don't favor a gold or a silver standard and hold out hope that index futures convertibility on a centralized measure of monetary expenditures can be the basis of free banking. Under that sort of scheme, no individual bank needs to worry about what is happening to the actual value of nominal expenditure (though they will if they want to maximize profit,) but someone must. And I grant that with a gold or silver standard, it is possible for it to operate with no one worrying about the macro consequences. That the price of gold in terms of banknotes and checks must remain at par is an automatic consequence of redemptions. And that is the analogy. Still, as explained above, free banks would be wise (and more profitable) if they do pay attention to what his happening to the quantity of money (issued mostly by competitors) and the demand to hold money, the supply of saving and the demand for investment, and with a gold or silver standard, mining conditions and the industrial demand for the particular metal.

[Steve Horwitz]

Lee,

I will gladly acknowledge that volatility in the demand for money would not be a huge concern in the free market/free banking world, but it wouldn't be irrelevant either. Even in the world we live in today, changes in MD are much less likely to be a source of trouble than changes in the MS of course. There are, however, still two good reasons to "tell the EDM story".

1. Such a scenario is possible and theoretical completeness demands that we account for it.

2. We do have some historical examples, the most notable of which being the early 1930s. If we can't explain that period, and I think you do need to talk about the problems caused by the fall in the MS, then we haven't done our jobs as monetary theorists, much less as economic historians.

So yes, the EDM scenario is less likely to actually bite us in the butt, but that doesn't mean we should ignore it theoretically.

[Lee Kelly]

Steve,

I did not mean to suggest that changes in money demand would cease to occur with free banking; my concern is that our present monetary institutions and regulations actually exacerbate such changes.

I think this is important. Keynes's "paradox of thrift" is among the primary justifications for government command and control of the money supply. But the "paradox," so far as I can tell, is really just an excess demand for money. Moreover, many of the government powers purportedly needed to prevent the "paradox" on the supply side, seem to have the unintended consequence of exacerbating problems on the demand side. I haven't encountered this argument being made by yourself, White, Selgin, Woolsey, or anyone else associated with FE/MET, but it seems like an interesting avenue of investigation.

[Current]

Regarding Nikolaj's quotes of Mises....

"It is unsound to distinguish between circulating and idle money. It is no less faulty to distinguish between circulating money and hoarded money. What is called hoarding is a height of cash holding which—according to the personal opinion of an observer— exceeds what is deemed normal and adequate. However, hoarding is cash
holding. Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal. He who hoards money believes that some special conditions make it expedient to accumulate a cash holding which exceeds the amount he himself would keep under different conditions, or other people keep, or an economist censuring his
action considers appropriate."

What Mises says here is quite correct and the Free-banker's don't disagree with it. The "composition problem" is essentially separate from the reason for holding money though. If many people can be demand a larger stock of money for the purpose of holding then that will cause a fall in prices and the associated costs of deflation.

Keynesians are quite wrong to blame the hoarding of money for the problem here. Trying to tackle the problem by reducing "hoarding" is nonsensical.

Nikolaj: "So: 1) Recession is brought about by an "insufficient suplpy of money" among other things. Really 'Misesian'. :)"

The argument is that recession is exacerbated by this, it is a secondary effect after real factors have brought about a recession. I don't think Mises made this argument, but Hayek did.

Mises did agree that if the government reduce the supply of money then that will cause a recession, he says so in several places. Especially relating to the revaluation of the pound in Britain in the 20s.

Nikolaj quotes Mises: "The existence of unused capacity is...by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which (in consequence of “misdirections of capital”) the necessary durable equipment is available...The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes".

How is this in disagreement with what Steve has said. One possibility is that idle capacity is caused by real factors, as Mises describes. That doesn't preclude idle capacity being caused by monetary factors. No simple empirical examination of whether idle resources exist can demonstrate what the situation is one way or the other.

Mises agreed that deflation causes the costs that Steve mentions. As I'm sure you know as he writes it in several places.

Free bankers disagree with Mises and early Hayek that the deflation involved after a recession is "purging" and different from other deflation.

I think Nikolaj is trying to exagerrate the differences between Mises and the modern Free bankers. Though I agree that there are certainly differences.

[fundamentalist]

Bill: "Suppose that the households increase saving by reducing consumption expenditures out of income, exactly as before, but instead of spending the money on corporate bonds, they instead increase their money balances. ... Assume that the banks expand their lending at this same time, and lend out newly created money exactly equal to the amount of money the households have accumulated. The quantity of money expands exactly the same amount as the demand to hold money."

Check my math, but it seems to me that the money supply doubles. It's not at all the same scenario that he previously described when consumers saved and bought bonds. In a fractional reserve system, the banks would loan out the cash holdings of consumers. Then when they created new money equal to the savings of consumers, the money supply would triple, not stay the same as the amount saved. That's because we would count 1) the money people put in their checking accounts, 2) count it again as banks loaned it out and 3) add the new credit created by the banks that was equal to the amount saved.

If, however, people reduced consumption and put their money under the mattress, that is, hoarded money, then the total money supply would fall and banks would need to create new money to replace the hoarded money in order to keep the money stock equal to the level before hoarding began.

And in a third scenario, if consumers reduced consumption but put the money in checking accounts with 100% reserve requirements, the money stock would remain the same; there would just be less consumption and no increase in investment. People would simply have adjusted their wealth to include more cash and less investment. If banks increased credit to an amount equal to net increase in cash holding, then the money stock would increase by the amount of the increased cash holdings. Businesses would borrow the new money and expand production without seeing an increase in demand and malinvestment would occur.

I think Bill still doesn't get Austrian econ. Malinvestment occurs only when businesses invest more than what people save for the purpose of investing. If the money stock is fixed and people reduce consumption to hold more cash that will not be re-invested, such as is the case with hoarding, then all that happens is that the consumer goods sector will slow down and eventually the capital goods sector will follow.

[Lawrence H. White]

Lee Kelly writes: "It seems to me there are numerous other ways in which governments may be creating a more volatile money demand. I would be curious to see any thoughts by commenters here on the matter."

Perhaps the most important way that the current fiat/central banking regime makes money demand more volatile (compared to a gold/free banking regime) is that inflation expectations are more volatile because the price level is unanchored. When expected inflation rises, desired real money balances fall ("velocity" rises). The consequence is to amplify swings in the purchasing power of money. Robert Barro wrote about this in a 1982 essay: http://www.nber.org/chapters/c11453.pdf?new_window=1

[Bill Woolsey]

Fundamentalist:

The money supply doesn't double.

Nothing is happening to cause a money multiplier process. I have no idea where you are getting deposits or withdraws of base money to or from the banking system.

All I can suggest is that you read again. The increase in the demand for money is money that is already in the bank. The increase in the supply of money is an increase in money created by the banks. Gold, tangible fiat currency, or whatever you like, has nothing to do with it.

Whatever you imagine is going on with currency drains or injections and the multiplied impacts on the quantity of money has nothing to do with Austrian economics. It is really quite standard--if that is what is happening. But that isn't what this discussion is about.

What it is exactly about is this assertion you make at the end about "saving for the purpose of investment." I argue that if saving is equal to investment, there is no malinvestmnet. The Rothbardians are trying to come up with this distinction between saving and saving for the purpose of investment, and it is bad economics. When you trace through the effects on interest rates and the demand for resources, you can see it makes no difference.

By the way, consumption slowing and capital goods following sounds kind of bad. Is that what you meant?

[fundamentalist]

Bill: “The money supply doesn't double.”

That depends on what you call money. Austrians consider gold, paper money (what you call base money) and credit are all money because they all have the same effect as money. No, base money is not increasing when banks loan money that didn’t come from savings. But credit expands and it has the same effect as an increase in gold, base money or any other kind of money.

Bill: “The increase in the supply of money is an increase in money created by the banks.”

Exactly! The bank is creating new money through credit expansion. Add that to what people have saved out of incomes and you have a doubling of the money supply.

Bill: “I argue that if saving is equal to investment, there is no malinvestmnet.”

That is standard Austrian economics. Whatever else you think Austrians believe is wrong. But to clarify, it has to read when ex-ante investment equals savings, there is no malinvestment. Ex-post investment always equals savings, by definition. In other words, if the plans that business people have coordinate well with savings, then there will be no malinvestment. Plans get out of sync with savings when banks create new money (via credit expansion) above what people have saved so that business people have plans for investment that are greater than the pool of savings.

Bill: “By the way, consumption slowing and capital goods following sounds kind of bad. Is that what you meant?”
In the context of hoarding or 100% reserve requirements, yes, that’s what would happen. Hoarding tells producers that consumers aren’t interested in the future. They are so scared now that they are piling up money for any contingency.
I have noticed that non-Austrians have a really hard time understanding analysis with a fixed stock of money (gold, paper or credit). But it is key to understanding Austrian economics, and reality. Many mainstream doctrines rest on the assumption of a growing money supply even though the economists using them don’t realize it.

[Steve Horwitz]

"I have noticed that non-Austrians have a really hard time understanding analysis with a fixed stock of money (gold, paper or credit). But it is key to understanding Austrian economics, and reality."

Not sure what you're getting at here. Are you saying that the developers of Austrian "macro" assumed a fixed stock of money? Do you mean "fixed" or "exogenous?"

[fundamentalist]

Steve,
No, but in separating out the effects of monetary policy, we first have to understand how the economy works without an increase in money before we can understand how it works after the money supply has increased.

For example, if the price of oil rises, then with a fixed money supply other prices must decline in order to channel money into oil. The prices of oil and all other commodities and assets can increase together only if the money supply is growing. That's impossible with a fixed money supply.

[Balsac the Jaws of Death]

Steve Horwitz writes:

"The argument of MET folks is that relying on the price level to do the work is extremely costly in terms of its macroeconomic effects. That's the argument about price not adjusting perfectly and instantaneously. During that adjustment process, we get the recession. "

Assuming this is true (about the stickiness of prices), isn't what happens under free banking an increase in the supply of fiduciary media, NOT base money/reserves? So, unless you ignore the distinction between demand for base money and demand for fiduciary media, aren't you making an apples-to-oranges comparison here? In other words, under a 100% reserve system, increased demand for money can only be met through changes in the price system (assuming production of the commodity money is too slow to be a factor here). But, under free banking, this increased demand can be met by a product that does not exist under 100% banking, namely fiduciary media. Is the comparison really valid unless you assume people are indifferent between holding base money and holding fiduciary media?

[Steve Horwitz]

Fundamentalist:

Ok, understood. And this is precisely what Bill and I are doing: assume a fixed money supply and analyze what happens when money demand rises. We get the recessionary consequences we've been discussing because the burden of adjustment rests on the millions of individual prices that will be affected by an economy wide attempt to economize on cash balances with a fixed money supply.

Then we ask "what happens if the money supply is sufficiently flexible to match that increased demand to hold money balances?" Bill's post does precisely that.

Wherein lies our problem as we seem to be doing exactly what you suggest?

[Steve Horwitz]

Balsac/Oderus/Flattus/Sleazy,

I'll be happy to respond to your question as soon as you pick one pseudonym and stick to it. We've banned folks for sock puppetry around here before. You're not explcitly pretending to be different people, but you owe the other commenters and your hosts the courtesy of our knowing that we're dealing with the same person on a repeated basis. Again, pseudonyms are fine, but please pick one and stick with it.

Consider that just a friendly request from your hosts.

[fundamentalist]

Steve: “Then we ask "what happens if the money supply is sufficiently flexible to match that increased demand to hold money balances?"

That’s what I intended to say earlier. The money supply increases by the amount of savings. I wrote that it doubled and that was wrong. But the money supply does increase due to bank lending not supported by savings.

Bill’s article: “While the demand for corporate bonds by the households falls, that is exactly offset by the increase in the demand for corporate bonds by the banks…. There is no change in the allocation of resources between the production of consumer goods for the nearer future and the production of consumer goods for the more distant future.”

As to the effect of that increase in money, it depends on where we are in the business cycle. I assume we’re at the bottom because people are hoarding money due to uncertainty and fear. So the new credit from the banks goes to purchase idle resources. After the unemployed workers become employed, they spend their larger incomes on increased demand for consumer goods. Since the new production methods haven’t increased the flow of consumer goods, yet, consumer prices rise. At this point, it’s appears that no malinvestment has taken place. The structure of production returns to the state at which it existed before the hoarding began.

At this point, what happens to the hoarded money? Do people continue to hoard it or do they spend it on greater consumption? If they gain confidence and start spending on consumer goods, the prices of consumer goods will continue to rise even faster because the new supply hasn’t reached store shelves yet. This is where the Ricardo Effect kicks in and triggers the bust of the boom.

Now had confidence returned to the hoarders and they started spending again without the banks’ infusion of credit, then the structure of production would return naturally to its pre-hoarding ratios between capital and consumer goods. But with the new money being spent on consumer goods in addition to the money from hoarding returning to consumption, consumer prices rise even higher and increase profits in the consumer goods industries, which in turn causes a shift in investment from capital to consumer goods and all of the workers in capital goods get fired and the depression starts again.

I think the key is that malinvestment never shows up until full employment returns. Until full employment, or something close to it, all investment looks good and it’s nearly impossible to tell what good investment is and what malinvestment is. Only at somewhere close to full employment when hoarding turns to consumption does it appear. Now if the hoarders continued to hoard in spite of less uncertainty and fear, those effects might not happen. But that seems unrealistic.

[Lee Kelly]

fundamentalist said: "The structure of production returns to the state at which it existed before the hoarding began."

Maybe, but not necessarily. If there has been malinvestment, then new credit is unlikely to return the economy to its previous state.

fundamentalist said: "At this point, what happens to the hoarded money? Do people continue to hoard it or do they spend it on greater consumption? If they gain confidence and start spending on consumer goods, the prices of consumer goods will continue to rise even faster because the new supply hasn’t reached store shelves yet."

This is incorrect. If money demand falls back to its previous level banks will have to contract the money supply by the same quantity that it was originally expanded. The general level of prices will remain unchanged, while relative prices reallocate resources away from previous malinvestments.

As bank customers begin increasing their spending--whether on financial assets or consumer goods, banks will be unable to finance the same quantity of loans, because more money will be needed to satisfy withdrawals.

[Steve Horwitz]

Fundamentalist wrote:

"The money supply increases by the amount of savings. I wrote that it doubled and that was wrong. But the money supply does increase due to bank lending not supported by savings. "

I've lost track of the context, but, again, if the increase in the money supply is due to bank lending, the bank is lending because its customers are holding higher money balances, which provides them with the requisite savings.

[fundamentalist]

Steve, I assumed hoarding or 100% reserves in Bill's account because that prevents money from being loaned out. However, if as you say the greater cash held by consumers gets loaned out again and banks don't create new money, I don't understand how Bill's scenario is different from regular Austrian econ. I'm missing something. What is Bill's complaint?

[Don Lloyd]

Fundamentalist,

"For example, if the price of oil rises, then with a fixed money supply other prices must decline in order to channel money into oil. The prices of oil and all other commodities and assets can increase together only if the money supply is growing. That's impossible with a fixed money supply."

This is completely wrong. It would only be true if you had no exchange-valued, non-money assets that you could could convert into money to make a purchase.

In theory, if you had fast enough computers, and no desire to hold money, a single dollar could support all the money transactions in the world.

Transactions do not consume money, only holding money ultimately is limited by its scarcity as a dollar can only be owned by one person at a time.

Regards, Don

[fundamentalist]

Never mind. I think I get it. Bill is saying that if people hold more cash, which gets loaned out by the banks and thereby increases the money supply, there is no malinvestment. But it seems to me that Bill has the wrong criteria for malinvestment. It appears that his criteria for saying that no malinvestment occurs is that “The price of the bonds and their yields do not change. There is no change in the market interest rate. The firms sell the same corporate bonds as before, but they sell them to the banks rather than the households. The firms purchase the exact same capital goods as before. The firms selling the capital goods have the exact same demand for resources, labor and existing capital goods as before. There is no change in relative prices and no change in the allocation of resources. There is no change in the structure of production between the production of goods of the lower order and goods of the higher orders. There is no change in the allocation of resources between the production of consumer goods for the nearer future and the production of consumer goods for the more distant future.”

In other words, interest rates, the ratio of capital to consumer goods, employment, etc. don’t change. And that is correct in the short run. And the short run could be several years in a depression. But is it sustainable? It is, but only as long as idle resources continue to exist. But the new workers in capital goods will buy them up before long. Then what happens when consumes stop holding so much cash? Remember they switched to cash only because of uncertainty caused by the depression. As the economy recovers, that uncertainty will disappear. When they begin consuming again as before, prices will become distorted and interest rates will rise. The malinvestment doesn’t appear until idle resources are used up and the boom is on the way.

[fundamentalist]

Lee: "This is incorrect. If money demand falls back to its previous level banks will have to contract the money supply by the same quantity that it was originally expanded."

How will banks contract the money supply by the same quantity? They will have loaned all of their money out to businesses. They won't start calling in loans and driving business customers into bankrupty. They may stop making new loans, but it will take a while to retire old loans as they are paid off.

But that demonstrates the malinvestment. The loans made from cash savings was only temporary because the desire to hold the cash was temporary, a result of the depression and uncertainty. While consumers were thinking of holding cash temporarily, banks were lending long term. Big mistake and classic malinvestment.

[fundamentalist]

Don: "This is completely wrong. It would only be true if you had no exchange-valued, non-money assets that you could could convert into money to make a purchase."

Wouldn't that make the price of those assets fall as people sold them? I was including assets in falling prices as people consumed less of other things to buy more oil.

[Current]

fundamentalist: "How will banks contract the money supply by the same quantity? They will have loaned all of their money out to businesses. They won't start calling in loans and driving business customers into bankrupty. They may stop making new loans, but it will take a while to retire old loans as they are paid off. "

For this reason the banks cannot safely make long-term loans in this situation. They must recognise a limitation on maturity-matching. For example, let's consider bank X, the combined demand deposits at bank X rose from £100million to £120million in one month. It would be foolish of the bank to lend out the extra 20million on long term loans, they must consider that their customers may quickly reduce their holdings.

If the bank gets this wrong it's an entrepreneurial error.

[fundamentalist]

It should be mentioned that in Mises' and Hayek's business cycle theories, credit expansion initially created the same circumstances as does savings. Interest rates fell and relative prices remained the same as investment and consumption increased at the same time. The malinvestment shows up only after a while, when the scarcity of capital raises its ugly head. That takes longer to happen when recovering from a depression than when considered in equilibrium.

[Don Lloyd]

Fundamentalist,

"...Wouldn't that make the price of those assets fall as people sold them? I was including assets in falling prices as people consumed less of other things to buy more oil...."

Not necessarily. First of all, refuting your claim doesn't require a large scale sale of assets. Secondly, the asset sold could be MMMF's, readily converted to money, but not a full medium of exchange itself, even if it is occasionally accepted in payment itself.

Regards, Don

[fundamentalist]

Don, It doesn't matter what type of assets are sold. And it doesn't matter that prices are determined at the margin. All prices of all products, including assets are determined at the margin. If more people sell than buy, then prices will fall. People could just pay for more expensive oil by using savings for a while, as long as they last. But savings won't last forever and long term depletion of savings would require a change in time preference.

[Don Lloyd]

Fundamentalist,

Your claim ties the quantity of money tightly to prices. If you believed this, you would logically have to expect a mojor decrease in market prices if 75% of the existing money supply were turned into equal dollar amounts of MMMF accounts with .01% yields.

This decrease will not occur, primarily because the vast majority of purchases do not need an accumulation of the actual medium of exchange for a long pre-purchase time duration.

Regards, Don

[Bill Woolsey]

Fundamentalist:

My argument about the equivalence of an increase in demand for money matched by an increase in the quantity of money created by lending and an increase in the demand for bonds starts at a point of equilibrium, and not at the bottom of the business cycle.

The end of my post does tie that argument into a scenario where the increase in the demand for money was due to unsettled conditions. There is no reason why this should suddenly happen at the bottom of the business cycle. Perhaps the peak or just past the peak? But it could be anything and have nothing to do with a predicted recession.

I linked to a previous post where I point out that treating temporary changes as permanent can lead to malinvestment. I think that is what you are assuming--that of course, temporary changes will be treated as permanent and create malinvestment.

The quantity of money is the total amount of money that exists. Saving is often treated as a fraction of income. An increase in saving can be characterized as a change in that fraction. In my argument, I really said nothing about that. It would be like, people save 100 billion more.

But that could be a 12 percent increase in the saving rate. Or .8 percent more of income being saved than before. These are fractions of income or of the fraction of income that is saved, not the quantity of money.

Anyway, in the scenario where they purchased bonds the supply of money doesn't change. It doesn't increase by 100b. It stays the same. Say, the quantity of money is $2,000 billion. The added saving of $100 billion isn't an increase in the money supply to $2,100 billion.

Suppose income was $15,000 billion and $3000 billion was saved. That would mean that $3100 billion was saved out of the $15,000 billion of income. Ignoring taxes, that means that consumption went rom $12,000 billion to $11,900b.

In the second scenario, the banks expand lending by $100 billion. The quantity of money goes from $2000 billion to $2100 billion. That would be a 5 percent increase. If the money supply were to double, it would go from $2 trillion to $4 trillion. See, the money supply didn't double unless it as only $100 billion to start

So, the first scenario there is no change in the quantity of money. It stays, say, $2 trillion. In the second scenario there is an increase in the quantity of money. As a fraction of the money supply it is the change in saving divided by the existing quantity of money.

Then I covered scenarios where there is no change in saving, but the quantity of money changes through added bank lending to match a change in the demand for money. There is a change in the allocation of saving from bonds to money. If the demand for money doubles (which would require that people shift more than their allocation of savings out of current income and shift their current asset portfolio, but that is possible,) then the quantity of money doubles.

There was nothing in my account about people earning income in the form of fiat currency or gold coins and either spending them on bonds or else depositing them in banks.

My assumption was that people receive income in form of checks which they deposit. They either spend them on bonds or else hold them. The banks either leave the quantity of checkable deposits the same or else make new loans by creating more checkable deposits. The impact of a new deposit of fiat currency into the banking system was not part of the story.

In a past comment, I tried to tell you that the money multilplier isn't 'Austrian economics." It is standard. Further, treating checkable deposits (and banknotes) as money as well as fiat currency or gold coins if such exist, is standard. If someone wants to defend the 19th century currency view of these deposits being credit not money, well, they have to do the explaining.

By the way, I come out of the Austrian school. But more of an amateur like you than formally trained. Still, I describe myself today as an "eclectic," really like Cowen, Caplan, and Selgin. (maybe they don't say "eclectic.") My formal training was "Virginia School." Anyway, you should be mindful of this when you explain to me what Austrians believe. I know something about it, and it strongly influences my current perspective. Further, if you read my post, I was not out to dispute Austrian economics at all. I was siding with some Austrian economists against others on one particular argument.

If people choose to increase their saving by purchasing bonds, and then after a short time, change their minds, then this is going to cause disruption. There is nothing specific to the creation of money about it.

If people sell bonds to hold money and banks create money and buy bonds, and then people change their minds and use the money to buy bonds, then the banks need to sell the bonds and extinguish money.

Why do you possibly think that having a generalized deflation of prices will help anything? And, by the way, the recovery is going to involve rising prices!

[fundamentalist]

Don: "Your claim ties the quantity of money tightly to prices."

No. I tie prices closely to demand.

[fundamentalist]

Bill: “I tried to tell you that the money multilplier isn't 'Austrian economics."

I’m not sure what you refer to by the money multiplier. The only multiplier I’m aware of is the one caused by fractional reserve banking as described by Hayek in “Monetary Theory and Trade Cycles” and De Soto in his book on banking.

Bill: “I describe myself today as an "eclectic," really like Cowen, Caplan, and Selgin.”

I have read Caplan and Cowen on Austrian economics and I’m pretty sure they don’t understand it. What they describe as Austrian is definitely not Austrian.

Bill: “I was not out to dispute Austrian economics at all. I was siding with some Austrian economists against others on one particular argument.”

I got that. The argument is that the increase in the money supply, caused by banks lending out the cash holding that people increased, doesn’t cause malinvestment because it doesn’t change relative prices or interest rates. I wrote above that that is not Mises’ or Hayek’s definition of malinvestment because they take a great deal of pains to demonstrate that an increase in the money supply via credit expansion has exactly the same initial effects as a simple increase in real savings. That’s how banks fool entrepreneurs. Credit expansion looks like real savings to entrepreneurs. In the Mises/Hayek model, consumers reduce consumption in both scenarios (saving and credit expansion) at first. The problem occurs when consumers reassert their natural consumption patters based on their time preferences, which hasn’t changed.

In your scenario, exactly the same thing happens. Relative prices and interest rates don’t change. But the problem of malinvestment becomes clear once consumers return to their normal consumption patterns and reduce their cash holdings. The process happens much quicker starting from equilibrium than from the bottom of a depression, but it happens just the same.

Malinvestment is the investment in new capital goods production when consumers want more consumer goods. Consumption patterns are based on time preference and change slowly. Holding larger than normal cash is a temporary thing brought about by uncertainty. Consumers will return to their normal consumption patterns as quickly as the uncertainty goes away. In the Mises/Hayek model, forced savings does the same thing. In both scenarios, malinvestment only appears when consumers return to normal consumption patterns.

[Don Lloyd]

Fundamentalist :

"...No. I tie prices closely to demand..."

But talking about the demand for money is incomplete. The two primary components of the demand for money are a demand for purchasing power and a demand for a medium of exchange. Actual money satisfies both demands simultaneously, while a MMMF can satisfy the demand for purchasing power, but not the demand for a medium of exchange. In reality, the demand for a medium of exchange is by far the smallest component of the demand for money.

Regards, Don

[fundamentalist]

Don: "But talking about the demand for money is incomplete."

I'm not talking about demand for money. I was talking about demand for other products. If people spend more money on gasoline (from oil) they will have less money to spend on other products. That changes their demand for those products. When demand for a product falls, the price falls.

[Don Lloyd]

Fundamentalist,

"...I'm not talking about demand for money. I was talking about demand for other products. If people spend more money on gasoline (from oil) they will have less money to spend on other products. That changes their demand for those products. When demand for a product falls, the price falls..."

Instead of 'spend more money', say 'expend more liquid assets' as whether the liquid asset involved is also a medium of exchange is seldom important.

Regards, Don