Final Sales of Domestic Product: First Quarter 2010

The GDP report came out, and as usual, the headline is the real GDP figure. Real GDP increased at a 3.2 percent annual rate in the first quarter of 2010.

However, I always scroll down to see what has happened to total cash expenditures. My preferred measure is Final Sales of Domestic Product. The value of the first quarter 2010 was $14,568 billion. The annual rate of increase was 2.51 percent.

The good news is that cash expenditures have nearly returned to their peak value before the recession of $14,583 billion in the 3rd quarter of 2008. The shortfall is less than .1 percent.

On the other hand, if cash expenditures had continued on its 5 percent trend growth path of the Great Moderation, it would now be $16,311 billion. The current level is 11.3 percent below trend.

Even with a modified growth path of 3 percent, changing at the peak in the third quarter of 2008, the target level would be $15,723 billion, and so the current value is 7.63 percent too low.

Worse, a 2.5 percent growth rate will never return to a higher 3 percent growth path, much less a 5 percent one. Surely, it is better for cash expenditures to rise rather than fall, but the current growth rate remains too low.

I believe that the Fed should commit to returning Final Sales of Domestic Product to the 3 percent modified growth path next year. It is now the second quarter of 2010, and so, one year from now, in the second quarter of 2011, cash expenditures should be $16,324 billion. That would be an increase of 12 percent from last quarter, or averaging a 9.6 percent annual growth rate for the current and next 3 quarters.

Russ Roberts on the Crisis

Russ Roberts of Cafe Hayek has an excellent paper on the Crisis--Gambling with Other People's Money.

Roberts blames the crisis on a pattern of creditor bailouts by government. The government has developed a policy of making sure that people who lend money don't suffer losses. On its face, that is absurd. Banks take losses from bad loans all the time. Robert's point, however, is that the households and businesses that lend to financial firms are shielded from these losses. He emphasizes that government policies are aimed at limiting the losses of any financial firm to stockholders of that particular firm.

For commercial banking, his account rings very true. Deposit insurance explicitly protects insured depositors from loss. Insured depositors have no reason to worry about the risks taken by their banks. Losses are borne first by the bank's stockholders and then by uninsured depositors and other creditors. However, FDIC has made it a habit to protect all of the uninsured depositors and other creditors from loss as well by using the "purchase and assumption" method of resolution for insolvent banks. FDIC guarantees enough of the bad assets of a failed institution, so that some larger, hopefully sound bank, will then take the remaining assets of the failed bank as well as take responsibility for all of its liabilities.

Roberts emphasizes that the GSEs, Freddie Mac and Fanny Mae, borrowed by selling bonds that had an implicit federal government guarantee. As expected, the lenders were protected from loss when Freddie Mac and Fanny Mae became insolvent. Harder to explain was lending to stand-alone investment banks, like Goldman Sachs, Morgan Stanley, Bear Sterns, and Lehman Brothers. None of these borrowed using insured deposits. There was no implicit government guarantee... oh wait. The government bailed out all of the creditors of these institutions except for Lehman Brothers.

Roberts builds a convincing argument that bailing out creditors leads to perverse incentives. However, I disagree with his claim:

The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.

I think that making equity holders take losses does reduce the moral hazard created by bailouts. For example, the initial TARP proposal was for the federal government to buy "toxic assets" from commercial and investment banks. This would bailout the banks for making bad loans, and so, the equity holders as well.

Fortunately, that plan was dropped. Instead, the TARP money was used to purchase stock in the banks. This resulted in some dilution of ownership, but it still involved bailing out stockholders.

If the various commercial and investment banks had been given the more standard FDIC treatment, all creditors would have been made good, but the stockholders would have been left with nothing. Bush and Paulson made moral hazard worse.

Robert's point, of course, is that even if the stockholders had lost everything and only the creditors were covered, there is still serious moral hazard. Before deposit insurance, banks needed to maintain higher capital ratios to attract depositors. The way to make sure that depositors or those holding the deposit-like short term commercial paper of investment banks insist on high capital ratios is for them to lose some money in banks that fail.

I think Roberts fails to emphasize the "bubble" element in the housing market. While he discussed a variety of government policies that were aimed at raising housing demand and so the equilibrium prices of homes, the "bubble" is the mistaken projection of past price increases into the future. In my view, this is what leads to the overshooting and an inevitable collapse.

If we think about "greater fool" investors, who understand that past price trends should not be projected into the future, but who believe that there are some "fools" who do and that profits can be made at their expense, the resulting "game" is very much like poker. This is especially true when the goal is to fleece not only the fools, but also others seeking to sell out to greater fools. And it is in that poker game, that Robert's point about gambling with other people's money rings true.

I strongly disagree with part of Robert's conclusion:

Be aware that the Fed is certainly part of the problem and may not be part of the solution. The Fed created the artificially low interest rates that helped inflate the housing bubble. The Fed then raised interest rates too quickly with disastrous effects for the adjustable-rate mortgages encouraged by their low-interest- rate policy. Monetary policy should not be left to any self-proclaimed or publicly anointed maestro. Following an automatic money growth rule or the Taylor rule would have avoided much of the pain. Somebody needs to hold the Fed accountable for funding exuberance.

I am not sure that the Fed's excessively low interest rates were part of the problem. If the natural interest rate falls and the Fed properly allows the market interest rate to fall with it, then housing prices will rise.

Worse, following "the Taylor rule" or anything like it is a mistake. Interest rates should depend on supply and demand, not manipulations of the quantity of money by a central bank based upon observations of past inflation and estimates of an output gap. Further, a money growth rule is equally bad. Money is an economic good, and its quantity should adjust to the demand to hold it.

Naturally, I favor a target for a slow steady growth path of aggregate cash expenditures. To the degree possible, market forces should be allowed to freely adjust both interest rates and the quantity of money consistent with maintaining that stable macroeconomic background.

In conclusion, I must ask, what "crisis" do we mean. I believe that the Fed's policy of interest rate targeting was responsible for the real crisis that has left total cash expenditures about 10 percent below their long run growth path. I won't deny that a long standing policy of creditor bailouts was responsible for the solvency problems of leading Wall Street investment banks, and many commercial banks as well. The degree of malinvestment in housing, as well as the inevitable disruption to production when insolvent financial institutions are reorganized might also be laid at the door of this policy of creditor bailouts. But these things pale against the failure of the Federal Reserve to do its job--keeping aggregate cash expenditures on a stable growth path.

Speculative Bubbles and the Natural Interest Rate

One problem with "Austrian" Macroeconomic thinking is excessive focus on scenarios where the natural interest rate, and so, the supply of saving and demand for investment, is given. The "classic" scenario is where the demand to hold money is assumed given as well, and then an increase in the quantity of money pushes the market interest rate below the natural interest rate.

Suppose instead that investment demand increases because of a speculative bubble in housing. The "cause" is the projection of past price increases into the future. People invest in order to profit from those expected price increases. If there are people who will be willing to pay high prices for the houses in the future because they want to live in them, then there is nothing irrational about this investment plan. It is only a speculative bubble if the reason people are paying higher prices for the homes is that they plan to sell them to someone else at a still higher price, but that person will only pay that price because they plan to sell to still someone else at a yet higher price. It is a speculative bubble if there is no one at the end who is willing to pay the high price in order to live in the house.

Suppose that instead of this kind of bubble behavior, people are investing in houses now because radio messages are received from outer space. Alien settlers are on their way with ships full of great consumer goods. They will exchange those for houses when they arrive. Assuming the messages are true, then purchasing a home is a great investment project. It will generate large amounts of future output. (And, when the messages turn out to be a fraud, the result will be somewhat like the bursting of the speculative bubble.)

So, what are the effects of an increase in investment demand? Investment demand is made up of investment demands for all sorts of different types of capital goods by a variety of different firms. (This analysis includes residential investment demand by households along with the rest.) If the demand for residential investment increases, the sum of the demands increases as well.

At the existing level of the natural interest rate, the demand for investment is greater than the supply of saving. The natural interest rate is higher. Assuming that the market interest rate was equal to the natural interest rate before, and then rises with the natural interest rate, then the quantity of investment demanded will fall and the quantity of saving supplied will rise. At the new equilibrium, the amount saved and invested are both higher. This increase in the amount saved is equivalent to a decrease in the amount consumed. Less is spent on consumer goods and services. The increase in the amount invested is an increase in the purchases of capital goods. There is a shift in the allocation of resources.

The increase in the market interest rate to some degree chokes off the increase in the demand for residential housing. However, it also reduces the demand for all other types of capital goods. Naturally, there will be an increase in the derived demand for sawmills, forests, brickyards, and the like. But like the homes themselves, these added derived demands will be dampened by the higher market interest rates. Still, there are presumably some capital goods less directly related to housing production that will also see their demands fall due to the higher interest rate.

The increased market and natural interest rates imply an increase income from capital. Other things being equal, that would be an increase in aggregate income. How is that possible? If the basic identify of macroeconomics is that aggregate income is always equal to output, then how can those earning greater capital incomes do so when output is limited by the existing productive capacity? It is because the new homes are worth more than the other capital goods (or currently produced consumer goods and services) being sacrificed.

In the scenario of a speculative bubble, this greater value is an illusion by assumption. With the alien immigrant scenario, the value of the bonanza of products they will bring is being pulled into the present.

What about labor? Those constructing new homes to take advantage of their high prices demand more labor. Wages rise so that those producing other capital goods and consumer goods will use less labor, freeing up the labor needed to construct new homes. Assuming that the quantity of labor supplied rises in response to higher real wages, the quantity of labor used in production rises. This increase in labor input provides a second, more tangible source of added current production.

The result of the great profits that can be generated from housing production (or more exactly, the expectations of those profits) results in higher real wages and higher real capital incomes. Because the homes and capital goods used to produce houses are so valuable, real output rises just from the shift in the composition of output, and then it also rises because higher real wages draw out more labor input.

This real boom is consistent with scarcity. Leisure, other capital goods, and so far, current consumer goods are being sacrificed. Housing and capital goods used to produce housing are being produced. The illusion of created by the speculative bubble (or the space alien settlers) is motivating these sacrifices and creating the real boom.

Is it conceivable that current consumption could rise in this boom? To the degree that higher real wages bring forth an increased quantity of labor, it is obvious that current consumption can rise. As the workers earn higher incomes, it is likely that they will increase their current consumption.

Even ignoring this effect, it would be possible for those receiving increased capital incomes to expand their consumption. Resources, including labor and existing capital goods, can be stripped from various capital projects, for example, dams, and used to produce consumer goods and new homes. Income, output, and consumption can all expand because the houses being produced are so much more valuable than the dam project.

So leisure and alternative capital projects are sacrificed, and real wages, employment, real labor income, real capital income, the real capital stock (including houses,) aggregate real income, aggregate real output all expand. If the cause was the alien immigration, then when they arrive, the past sacrifices are shown to be justified. The sacrificed capital projects (the dam) don't produce output, but the trade goods brought by the aliens compensate for the sacrificed products.

But suppose the aliens don't arrive. Suppose it turns out that the radio messages were a fraud. Everything must go into reverse. Real wages must be lower. Employment will be lower. The real capital stock will fall. All of those houses aren't so valuable after all. Real capital incomes must fall. The production of consumer goods must fall.

Of course, if the cause of the great profits in housing was a speculative bubble, then it was always a fraud. That is, it must eventually end.

In my view, the best macroeconomic environment to for the necessary readjustments is to keep total cash expenditures on a stable growth path. While real wages and real capital incomes may need to fall (and certainly grow more slowly for a time,) stable growth in nominal incomes imply that this will require price inflation to a higher price level. If the failure of nominal wages to keep up with inflation results in people quitting work or dropping out of the labor force, this is the proper response. The decrease in labor input will reduce the productive capacity of the economy, but at the same time that the loss in real income reduces the demand for consumer goods. And, of course, the lower real interest rates may well cause reduced saving out of that reduced income, and at the same time increase the profitability of those investment projects that had been crowded out by the housing investment.

I hope that my analysis of the impact of an increase in the demand for investment has been suggestive. Could something like this have occurred during the housing boom? Suppose central banks are targeting the market interest rate so that increased investment demand results in an excess supply of money? Certainly more analysis is necessary. But recognizing that the natural interest rate can and does change is a good start.

Recalculation--Two Versions

Arnold Kling has claimed that the current recession is due to a need to "recalculate." There are really two versions of the argument. As Frank Knight said of Keynes, I will argue that what is correct isn't new. And that what is new isn't correct.

Looking back at the housing boom in the past decade, there is good reason to believe that there has been substantial malinvestment. Too many homes have been built. Various capital goods have been produced that are specific to the production of housing. There is a similar problem with human capital--too many skilled carpenters.

With hindsight, fewer houses should have been produced. Fewer capital goods specific to housing construction should have been produced. Less carpenter skills should have been developed. Instead, other goods and services should have been produced, including both physical and human capital specific to other industries.

While those are all sunk costs at this point, it remains necessary to expand the production of other, more valuable goods. This involves shifting labor and other resources away from housing construction to the production of other goods and services.

During this process, the unemployment rate for labor will be relatively high. There is a longstanding term for this type of unemployment--structural unemployment. If the unemployment rate is relatively high, the employment rate is relatively low. The productive capacity of the economy is depressed.

Added to this problem is the fact that human and physical capital specific to housing construction are lost. New capital goods must be constructed and new skills developed. Labor productivity should be depressed even after labor is absorbed. The productive capacity of the economy will only gradually recover.

Personally, I think the term "recalculation" is inappropriate to describe this adjustment process. Perhaps "redeployment" is the better term. A shift from goods that were being overproduced to the goods that are currently being underproduced is a redeployment of resources.

That such a redeployment is likely occurring is important to keep in mind. For many years, monetary and fiscal policy was aimed at stabilizing unemployment or real output. If structural unemployment is currently high and productive capacity low, seeking to use expansionary monetary and fiscal policies to return unemployment to where it was before this redeployment began would be a mistake. Similarly, seeking to return employment and output to their pre-redeployment growth paths would be a mistake.

However, when Kling began using the term "recalculation," he sometimes described a quite different scenario which is not a redeployment of resources from what was overproduced to what is underproduced. Rather, he suggests that we must pause, and leave resources unemployed while we determine what to do with them. Of course, there is no "we" making conscious decisions, but Kling argued that "the market" must similarly pause to decide what to do, and so there is a "recalculation."

I believe that this conception of recalculation is inconsistent with the most important principle of economics--scarcity. There are not enough resources--land, labor, and capital--to produce all the goods and services that people can use to achieve their goals. It is certainly possible for a particular good to be produced in such large quantities that isn't scarce. Or even that it be produced to the point that some of it becomes garbage and someone must be paid to dispose of the excess.

It is conceivable that all tangible goods and services could be produced in quantities where none of them are scarce, but that isn't the situation that faces the world today. Billions of people in the world could use more of any number of existing goods.

Under conditions of scarcity, overproduction of any one good means that some of the good is worth less than its opportunity cost, which is the other goods or services that the resources could have been used to produce instead. To say that homes were overproduced is not to say that they are not scarce much less that some are garbage. It is rather to say that the other goods and services that could have been produced are more valuable. And to say that fewer homes should be produced today is not to say that no one could use the additional houses, much less that they will need to be demolished. It is to say that the resources that would be needed to continue to produce new homes at the rates typical during the boom have more valuable alternative uses. The other goods or services they could be used to produced are more valuable than those additional houses. And so, there is a need to redeploy resources.

Suppose, on the other hand, that the economy doesn't face scarcity. I don't want to tease out all the implications of this assumption--zero prices and wages--for example. No, assume that people decide that they don't want to purchase new homes, and there is nothing else that they want to buy. And so, until it is possible to figure out some new good that they want to buy instead of houses, there is nothing for people to do. They must wait around.

In a world of scarcity, this really isn't an issue. There are many things that people want to buy instead of houses. They bought the houses because they valued them more than the other things they could have instead used their income to buy. If they decide houses are not so desirable to buy, they buy other things instead.

Of course, the analysis above ignores leisure. It is possible that scarcity exists because leisure is valuable. People work in order to earn income to purchase new homes. They decide they no longer want to do that, and so they work less and earn less and purchase fewer new homes. Fewer homes are produced, so total output is lower. Fewer people work because they prefer more leisure, and so, there is less employment.

When someone comes up with a new good people want to buy, then people will go to work to earn the income to buy it. And firms will hire workers to produce it. Then why is output and employment low now? Because no one has determined what good they want instead of new homes. We know we don't want a bunch of new homes. But we must decide what we do want. We must "recalculate." Meanwhile, we enjoy leisure.

Unfortunately, this appears to be a very poor explanation of involuntary unemployment. It is rather an explanation of long vacations taken by people now have everything they need. It doesn't fit in well with people cutting back their purchases because they have lost their jobs. I personally know people who are new entrants into the labor force. They are currently unemployed and would like to work. The reason they would like to work is to purchase any number of existing goods and services.

Of course, if Robinson Crusoe finished up his house, and didn't want a second home, and had nothing else he wanted, then he would simply take it easy. He would take a vacation and have all the goods and services he could use.

But perhaps the problem is one of distribution. Some people, call them "the rich," have all the goods and services they can use. They don't want new homes. And so they buy less. And they work less. Meanwhile, other people, call them "the poor," have many goods and services they they want to buy. And so they work, earn income, and buy them.

Total output and employment fall because the rich don't want new homes and there is nothing else they want. So they work less and earn less income. Meanwhile, the people who face scarcity continue to work, earn income, and purchase goods and services. Once "the rich" discover some new good they want to buy, they will go back to work, and earn income to buy it. And firms will hire "the rich," so that they can produce this new good desired by "the rich," as well as continuing to produce the goods the poor continue to buy.

Unfortunately, this still appears inconsistent with people who face scarcity being unable to find work and earn income to buy the things they want. Of course, those "poor" people who produced houses no longer have customers. But those rich people who were producing goods for the poor no longer want to work. So the firms producing those goods have less labor. There is a need to redeploy resources. "The poor," who used to provide labor to produce new homes for "the rich," must shift to producing goods for "the poor." "The rich" reduce how much they work and how much income they earn, because they don't have anything they want to buy.

But, of course, I am imagining that people who have nothing they want to buy have no interest in earning income, and so they work less. Suppose that instead they save. They continue to work and earn income, saving that money so that they will be able to purchase these new goods and services that they might want to buy if and when they appear.

Note that this version of recalculation is very similar to naive Keynesian economics. Add the notion that the reason people save more is because they can't think of anything to buy, then we have an increase in saving, less spending on consumer goods and services, and so less derived demand for labor. The supply of labor isn't reduced. And so, a surplus of labor.

The approach is also very similar to Marxism. There are unemployed people who need goods and services. But they have no income. The income is being earned by "the rich" who have nothing they want to buy. They simply save the money. While coming up with some kind of new luxury good for the rich to consume might help, an alternative is to redistribute income to those who need it. They will spend the money they receive, increase the demand for goods, and create more employment.

But increased saving should allow for additional investment--spending on new capital goods. These capital goods will allow for the production of additional consumer goods in the future. However, in the recalculation story, no one knows what consumer goods will be demanded in the future, and so what capital goods should be purchased. In fact, "the rich" were purchasing new homes as a speculative investment. Once they no longer want to buy homes for that purpose, and there is nothing else for them to buy, they will continue to save, without there being any investment.

If people want to save more than they want to invest, interest rates should fall. And, in fact, during the current crisis "the" interest rate has fallen nearly to zero. But apparently, this lower interest rate has not motivated "the rich" to consume more. They have nothing more to buy. And the lower interest rate hasn't motivated them to purchase capital goods. Because they don't know what capital goods are appropriate.

But how can people save without there being matching investment? They must accumulate money balances. And so, "the rich" want to earn income, and save it, in order to be able to purchase new consumer goods in the future that might be developed. They don't want to invest in capital goods until they know what consumer goods that people like them will want to buy and so what particular capital goods are appropriate.

And so, they work and earn income, and save by accumulating money. They aren't accumulating money because there is a certain amount of real balances they want, and once they have accumulated those, they can go back to purchasing one of the many goods and services they have been sacrificing in order to build up those money balances. They aren't sacrificing goods and services to add to money balances. They are accumulating them in case some new good arrives that they will want to buy.

I don't want to claim that no one could possibly behave in this fashion. I called them "the rich," for a reason. To me, it is only the very rich that might be in this situation where they have everything they want to buy but rather than enjoy leisure continue to earn in order to be able to buy something that they might want in the future. Because incomes are so skewed, even if there are a small number of people like this, this behavior could conceivably have a significant effect on the economy.

As explained above, the argument is Keynesian in that it suggests there is too much saving. It is Marxist in that their appears to be a problem of distribution. (I am dismissing the possibility that anyone would be so blind to the reality that the vast majority of people have an entire list of goods and services that they would buy if they had additional income.)

I think it is obvious that having people who face scarcity--want to work to earn income to purchase goods and services--remain unemployed because other people want to work to accumulate money because they might want to buy something in the future is unacceptable. Making those facing scarcity, "the poor," pause until someone comes up with something "the rich" want to buy is a coordination failure.

It seems to me that the solution is that "the rich" need to work less. There is no point to saving if it isn't funding investment. If people don't want to invest, then they shouldn't save. If people are only working in order to save, then if they save less, they have no reason to work. And, so, if the market system is going to provide proper coordination, there must be a signal for these sorts of people to work less in this situation.

In my view, the market signal is obvious. The real interest rate from holding money must turn sufficiently negative to clear markets. Those who want to work now and save because they might want to buy something in the future, and they don't want to invest in capital goods because no one knows what particular capital goods are appropriate, need to pay in order to save. And if they don't want to pay, then they should work less.

In conclusion, redeployment of resources, including labor, is something that happens all the time. The notion that it always happens at a constant rate is implausible. It seems likely that the aftermath of the housing bubble requires more redeployment of resources than usual. This might raise unemployment and depress output for some time. However, redeployment means redeployment to somewhere else. There are plenty of scarce goods and services to produce, and so, there should be sectors of the economy with rising prices and profits, and rising production and employment.

The notion that it is somehow necessary to "pause" and have some industries shrink, nothing expand, and just wait until someone figures out something to do, is inconsistent with scarcity. With certain Marxist assumptions (the rich don't face scarcity) and Keynesian assumptions (people want to save but no one wants to invest because of uncertainty,) it is possible to explain such a "pause." But in the end, it always comes down to monetary disequilibrium.

Cowen on Say's Law

Tyler Cowen argues that even in aggregate demand is too low, supply still matters.

In a world of unemployed resources, imagine a company called Apple invents a device called -- improbably -- an iPad. That's a positive supply shock. People will be lead to spend more money. The inventors and their employees will have more money to spend. There will be a positive multiplier throughout the economy, as analyzed by W.H. Hutt. First aggregate supply went up and then aggregate demand went up. It's all one step on the way to economic recovery.

Why don't the people buying the ipads spend more on ipads and less on other goods? Naturally, one would think they would spend less on substitutes for ipads.

From a flow perspective, Cowen is assuming that the ipad consumers are choosing to reduce saving. This raises the natural interest rate. If the market interest rate is unchanged, say because of central bank policy, nominal and real expenditure expands. This expansion ends if and when higher current income raises saving again and so the natural interest rate equals the market interest rate.

From a stock perspective Cowen is assuming that the ipad consumers choose to hold less money. Given the quantity of money, nominal and real expenditure expands. This process ends when real income rises enough so that the demand to hold money again rises to the existing quantity of money.

The flow and stock perspectives are consistent, though perhaps the flow approach is more appropriate if the central bank adjusts the quantity of money to target market interest rates. In both, nominal expenditure and aggregate demand depend on the quantity of money and the demand to hold it.

Perhaps it is sensible to assume that the introduction of a new good will cause a decrease in the demand for money. And so, it will raise aggregate demand.

On the other hand, surely most of the effect will be a shift in the composition of consumption and unchanged desired money holdings.

Ignoring this immediate effect, consider the multiplier Cowen describes. What I always call the "Yeager" effect becomes important. The increase in ipad production raises output. Assuming money is a normal good, the increase in income raises money demand. If the quantity of money is unchanged, the resulting shortage of money results in people reducing nominal expenditures. If this Hutt/Keynes multiplier results in those with greater income spending more, and additional production in response, the demand for money is rising at each step. In other words, this process is impossible.

The true "multiplier" effect is just the fundamental proposition of monetary theory. Individuals with excess money balances spend them and people accept them in payment not because they want to hold more money, but in order to spend them in turn. The process ends when demand for money adjusts to the quantity.

If the demand for money changes, and the quantity of money is unchanged, the fundamental proposition of monetary theory suggests that one person adjusts spending and then another, until the demand for money returns to its previous level.

If there is insufficient aggregate demand, a increase in supplies of goods and services that causes lower prices will increase the real supply of money, which raises aggregate demand. And, I don't disagree that the introduction of a new good would plausibly cause a substitution away from many other things, and that one of them is money, and so it would help a bit.

But monetary disequilibrium-- the quantity of money and the demand to hold money--is central to understanding inadequate aggregate demand.

Malinvestment and the Liquidity Effect

Austrian theorists typically downplay or dismiss the "liquidity effect" of monetary disequilibrium on market interest rates. Instead, they champion a loanable funds explanation of interest rates, with an excess supply of money impacting interest rates by creating a matching increase in the supply of credit. This is sometimes called the "injection effect" of money on credit and interest rates.

New Keynesian economists, on the other hand, make the liquidity effect of money on interest rates central to their very understanding of money. It seems that the dominant perspective somehow identifies money with the short term interest rates set by central banks.

This divergence in perspective hit home recently due to two books I am reading. The difference is obvious in the introductions in Steve Horwitz's Microfoundations and Macroeconomics: An Austrian Perspective, and Michael Woodford's Interest and Prices.

Horwitz criticizes IS-LM analysis in a way that I found too dismissive of the liquidity effect of monetary disequilibrium. Similarly, I recently read a chapter by Roger Garrison explaining the "loanable funds" approach to interest. While he mentions that saved funds might not be lent out, his approach is to give reasons why the hoarding of money should be minimal.

Woodford, on the other hand, defends his modeling strategy of ignoring the quantity of money and just treating Federal Reserve policy as setting short term interest rates. He mentions that a money demand function can be appended to the model, and that would determine the quantity of money. Presumably, the model "determines" the quantity of money that creates whatever liquidity effect necessary to keep the short term interest rate where the central bank wants it.

Woodford also discusses cashless payments systems, and argues that if such a system actually develops, then the quantity of money will become meaningless and the only way a central bank could implement policy is through targeting the interest rate. He explains that a "channel" policy, where the central bank sets a lending rate and pays interest on reserve balances will keep short term rates in the channel between those rates, even if there is no money.

Cashless payments systems have been a special interest of mine, and I believe that they do have money. Woodford, however, seems to identify money as some asset or assets that will be subject to a liquidity effect. To him, "cashlessness" seems to mean the absence of an asset that people will hold even though its yield is less than the yield on other sorts of securities.

In my discussion of the disequilibrium version of the Austrian cycle theory, I described what I understand to be the injection effect. Given appropriate institutional assumptions, an excess supply of money will be matched by an increase in the real supply of credit. This increase in the real supply of credit will result in a lower market interest rate. I have asserted that this effect is ephemeral, because it only exists as long as there is an excess supply of money. And doesn't an excess supply of money mean that people are holding more money than they want to hold? How long can that last? People holding more money than they want to hold spend it.

Suppose that this injection effect is understood in the context of the liquidity effect. The liquidity effect also depends on institutional assumptions. The most important one is that the nominal interest rate that can be earned on money is "sticky." With conventional, tangible, hand-to-hand currency the nominal interest rate is stuck at zero. To the degree that issuing deposit money requires banks to hold vault cash made up of zero interest currency, or clearing balances with interest stuck at zero or some other rate (or even sticky) then some of the characteristics of the interest (or lack thereof) on currency will be partially transferred to the interest rate paid on deposits. If government regulations prohibit the payment of interest on various classes of deposits, and the "rents" provided by this anti-competitive regulation can only be dissipated through quality competition, an even greater stickiness is assured. And, of course, it is possible that competing private banks would offer deposits that pay interest that is only periodically adjusted. The stickiness of the interest rate paid on money could be a market phenomenon.

If there is some source of stickiness in the interest rate paid on money, then changes in market interest rates impact the opportunity cost of money and should be negatively related to the demand to hold money. If, on the other hand, the interest rates paid on monetary assets moved with other interest rates, then this effect would not exist. If the interest rates paid on money are sticky, then the interest rate elasticity of the demand for money could be significant in the short run, but then dissipate over time.

Even if the demand for money was perfectly inelastic with respect to interest rates, perhaps because the interest rates paid on money adjusted instantaneously, there would still be an injection effect of an excess supply of money. However, suppose that the interest rates on money are sticky, so that as the increase in the real supply of credit reduces market interest rates, it also reduces the opportunity cost of holding money. The amount of money demanded rises to match the expanded supply. People are satisfied with the existing quantity of money. The only problem is that the market interest rate is below the natural interest rate. That is, saving is less than investment.

In an earlier post I discussed the liquidity effect and explained my view that an excess supply of money exists when the quantity of money is greater than what the demand for money would be given the existing interest rate paid on money and a market interest rate is equal to the natural interest rate. That market interest rates may be distorted so that they do not properly coordinate saving and investment is one of symptoms and negative consequences of monetary disequilibrium.

If the institutional conditions hold for both an injection effect and a liquidity effect, it seems plausible that a persistent effect on market interest rates is possible. Only as lower market interest rates begin to impact savings (and so consumption) and investment, does the monetary disequilibrium begin to impact aggregate demand for final goods and services. And, of course, this plausibly impacts the composition of demand, in the end, based upon the interest elasticities of demand for various goods and services.

Perhaps this is just a situation where I have unusual intuitions, but the idea that people are simply holding more money than they want seems unlikely to last long. People will spend the money. But that people may take time to respond to changes in interest rates is much more plausible. And at least one requirement for malinvestment to be a problem is for monetary disequilibrium to have a persistent impact on market interest rates.

Where Did Mises Go Wrong?

The public finance approach to inflation starts with an "inflation tax" and reasons that the revenue generated from that tax can persistently impact the allocation of resources. In the example where the revenue is used to purchase tanks, the number of tanks a given inflation rate will allow the government to purchase in long run equilibrium can be characterized in terms of the price elasticities of supply and demand for tanks, the inflation rate, the quantity of real balances and how the demand for real balances responds to changes in the inflation rate. Working in reverse then, it should be possible to choose how many tanks the government would like to purchase, and then work out the necessary inflation rate to allow that many to be purchased in equilibrium.

Suppose that instead the procedure is to posit that the government would like to purchase a certain quantity of tanks using money creation, and then describe what happens to the rate of money creation and the rate of price inflation during the adjustment process. Ignoring that the short run elasticity of supply of tanks is likely to be lower than the long run, and assuming there is already some kind of market for tanks, it would be possible to imagine that the government purchases the needed number of tanks at their current market price. Because the money is spent before it has lost any purchasing power, the government gets a bargain.

Interestingly, this traditional Austrian argument that those receiving the money relatively early, before prices have risen, benefit, can be related to a joint effect of the disequilibrium and public finance effects of inflation. If the quantity of money rises faster than prices, the real quantity of money rises. That is an increase in the base of the inflation tax. A given revenue can be generated with a lower tax rate if the base is larger. Again, leaving aside problems with short run price elasticity of supply of tanks, a smaller rate of money growth is needed to purchase the needed quantity of tanks if the expansion of the quantity of money creates an excess supply of money.

Of course, any such excess supply of money will be ephemeral. And once the real quantity of money has adjusted to the real demand to hold money, the base is smaller and so a greater rate of money growth and price inflation is needed to obtained the desired number of tanks.

But the process doesn't stop there. Price inflation makes holding real money balances more costly, and so, the demand for real money balances falls. This raises the rate of money growth and the rate of price inflation needed to obtain sufficient real revenue to purchase the desired number of tanks.

And so, we see at least two reasons why obtaining the desired number of tanks requires that the government expand the rate of money growth and so the rate of inflation. However, in the end, we are left with the same inflation calculated from the long run elasticities of supply and demand for tanks and the elasticity of demand for real money balances with respect to the inflation rate. That inflation rate and the tank purchases can persist as long as money holders/taxpayers put up with the program.

Mises on the other hand, was constantly drawn to describing a process by which the rate of money creation and price inflation must rise higher and higher until the demand for real money balances falls to zero, and money has no value. Where did he go wrong?

The "laffer curve" may be a subject of some derision, but it is an implication of basic public finance. Tax revenue is found by multiplying the tax rate by the tax base. And typically, the tax base is negatively related to the tax rate. A low rate then, allows for a high base but a low revenue. A very high rate that results in a very low base and also a low revenue. There should be some intermediate tax rate that results in some intermediate base that generates the maximum amount of revenue.

Applying this concept to the inflation tax, a low inflation rate results in a very large demand for real money balances, but the low rate and high base generates a low revenue. A very high inflation rate results in in a very low demand for real money balances. The high rate and low base also generates a low revenue. At some intermediate inflation rate and some intermediate level of real balances, the maximum revenue is generated.

Assuming that the inflation tax is earmarked to the purchase of tanks, the maximum revenue that can be generated by the inflation tax, along with the price elasticities of supply and demand determines a maximum quantity of tanks that the government can purchase from the inflation tax.

Suppose that the government decides to use the inflation tax to purchase a number of tanks that is greater than that maximum? Suppose that the government can obtain that number of tanks in the short run because of the increase in the tax base resulting from a temporary excess supply of money, or else, because the demand for real money balances only gradually responds to the higher cost of holding balances. The short run elasticity of demand for real money balance with respect of inflation becomes more elastic over time.

The rational expectations equilibrium for this scenario is that money loses all value and the government purchases absolutely no tanks using the inflation tax. However, it is possible to imagine a gradual process by which the government obtains a large amount of tanks initially, but that it as it raises the rate of money creation and inflation to try to continue this volume of purchases, inflation becomes higher and higher, and the real demand for money falls, until this futile process results in money having no value.

Mises, of course, didn't describe this in the context of the use of the inflation tax to purchase tanks. Rather, he described it in terms of the use of money creation to lower real interest rates. The reason to lower interest rates was to stimulate the production of capital goods. Or mpore precisely, to shift production of consumer goods to the more distant future. Rather than think about how a particular rate of money creation would impact the composition of demand and the allocation of resources, the assumed rate of money creation is allowed to vary to maintain the desired impact on real interest rates and the demand for capital goods.

If the only process at work is the creation of an excess supply of money, then no persistent impact is possible. But even including the public finance effect, if the initial size of the targeted change in real interest rate and the demand for capital goods is beyond what can be stimulated by subsidies funded by the maximum revenue that can be generated by the inflation tax in the long run, then a futile effort to raise the inflation rates to maintain the effect on interest rates and the demand for capital goods will eventually destroy the value of money.

More Austrian Cycle Theory

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

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

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

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

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

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

No. It doesn't.

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

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

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

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

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

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

Austrian Business Cycle Theory 3: Public Finance

Many years ago, I read a paper by Richard Wagner that applied public finance principles to the Austrian Business Cycle theory. While there are many ideas in the paper, the key idea I took from the paper is that of course inflation impacts the allocation of resources. Why would a government run an inflationary policy if not to shift resources to its supporters?

I will describe an Austrian theory that is at least loosely based upon his argument. This is an equilibrium theory that allows for a sustainable change in the allocation of resources.

Contrary to the traditional exposition of the Austrian theory, I will begin by ignoring interest rates, consumption, and investment. Instead, I will describe malinvestment in the context of the market for tanks.

The economy in question is static. There is no economic growth. The money in the economy is a tangible, hand-to-hand fiat currency. The quantity of this currency has remained constant for some time. The currency is issued by the government, and it makes no commitment regarding its purchasing power or nominal quantity. The demand to hold this money has been unchanging as well. The price level has been stable.

The government determines that national security requires that it build up large force of tanks. Or perhaps a tank salesman has friends in high places. Further, imposing an explicit tax is politically impossible.

To solve this "problem" the government decides to print new money to to purchase the desired tanks. In other words, the government decides to use an inflation tax to fund government spending.

Suppose the government decides to impose an inflation tax of 10 percent each year. The government increases the quantity of money by 10 percent each year. In equilibrium, the price level rises at an annual rate of 10 percent.

This is called an inflation tax because it makes holding real money balances costly. The cost is the decrease in the purchasing power of money held . That is, of course, the same thing as the rate of increase in the price level. The cost of holding money balances is now 10 percent per year. (It is conventional to add to this the real interest rate to get the opportunity cost of holding money relative to financial assets.)

Because holding money balances is more expensive, the demand for real money balances will fall. This involves a shift to a higher price level. The new, lower level of real balances that people choose to hold forms the base of the inflation tax. The rate is 10 percent by assumption. The real revenue generated by the tax is found by multiplying the base times the rate. Again, this revenue is earmarked to the purchase of tanks.

While it is unlikely the economy will adjust immediately into this new equilibrium, for now, suppose that it does. Prices, including wages, instantly begin rising 10 percent a year. Nominal incomes begin rising 10% per year. The nominal quantity of money is rising 10 percent. The amount of real money balances that people hold remain constant. Real output remains constant.

However, the allocation of resources has changed. More tanks are produced. More resources are devoted to the production of tanks. Fewer resources are devoted to the production of other goods and services.

How is this possible? How does the tank industry capture additional resources from the rest of the economy?

The answer is simple. The inflation tax must be paid. In order to keep real balances unchanged, nominal money balances must be increased at the rate of inflation. This requires that nominal expenditures be less than nominal income. If all of nominal income were spent, nominal balances would be unchanged. With the rising price level, real balances would be falling.

For example, suppose Smith earned $50,000 per year and spent $50,000 on consumer goods and services and various securities. Smith held real money balances of $2,500. Suppose that prices and nominal incomes both rise 10%. Smith now earns $55,000. If Smith spends $55,000 on consumer goods and services and various securities, then Smith's nominal money holdings remain $2,500. Unfortunately, that purchases 10 percent less. To maintain the same command over goods and services, Smith needs $2,750 -- 10 percent more dollars. In order to obtain that, Smith must reduce nominal expenditures spending to $54,750.

Dividing through by the price level, these relationships imply that real expenditure must be less than real income. Goods and services are produced and incomes are earned, but households and firms in the private sector purchase fewer goods and services than they produce.

How is this consistent with equilibrium? The government's nominal and real expenditure on tanks closes the gap.

The decrease in real expenditures on various private goods and services reduces their demands. This frees up resources in order to produce the additional tanks. The government purchase of tanks creates a derived demand for the resources needed to produce the tanks.

If the economy really did immediately jump to the new equilibrium composition of demands, real expenditures on private goods and services would drop at the same time the real expenditures on tanks rises. This change in the composition of demand would result in structural unemployment. It will take time for workers to be absorbed in tank production from the other goods that are being sacrificed. Since the structurally unemployed workers aren't producing anything (other than leisure,) aggregate output is depressed until the workers are absorbed into tank production.

What about capital goods? Since capital goods are heterogeneous, the capital goods that had been built to produce the various private goods and services that are being sacrificed might be useless in producing tanks. Others might be helpful in producing tanks to some degree, but much less appropriate to tank production than for their previous employments.

Because the productive capacity of the economy depends on the particular goods being produced, the shift from private goods and services to tanks will result in temporarily lower aggregate output. That is, in the short run, the additional tanks that can be obtained will be less than what will finally be obtained once appropriate capital goods are constructed.

After there has been a complete adjustment to the new composition of demand, unemployment and output return to their previous level. The government is getting tanks. Those using money bear the cost of inflation. The price level is rising 10 percent a year. There is no economic reason why this situation cannot be permanent.

The situation is little different from any other tax. Suppose that the tanks were funded by an income tax. Real income and output will be depressed a bit and leisure increased. The lower level of output and income is the tax base. Revenue is found by multiplying the rate times the base. After tax income is found by subtracting the revenue from income. Because of lower-after tax incomes, nominal and real expenditure on private goods and services is lower than nominal and real income. The government closes that gap by spending on the tanks. The lower demand for private goods and services and higher demand for tanks requires a reallocation of resources. Structural unemployment and the need to produce capital goods appropriate to tank production implies lower output and employment during the transition. While the lower level of output would presumably lower money demand and slightly raise the price level, there would be no persistent inflation in this scenario.

Returning the the inflation tax, suppose the taxpayers determine that whatever increase in national security the tanks provide is simply not worth the cost. Further, suppose they can influence politicians so that the inflation stops and tanks are no longer purchased.

The demand for tanks falls (to zero.) There will be layoffs in the tank producing industry. However, the inflation tax now disappears. Since holding money balances is now less costly, the demand for real balances expand. This requires a slightly lower price level. After that adjustment, the price level is stable.

No longer do household and firms need to constantly build their nominal money balances to maintain their real money balances. Prices are stable. Constant nominal money balances provide for constant real money balances. Nominal and real expenditures can now be increased to match nominal and real incomes. Whatever it is that households and firms choose to purchase with that part of real income no longer needed to pay the inflation tax enjoy increased demand.

Assuming the economy had fully adjusted to the previous composition of demand, structural unemployment will be associated with the shift in the allocation of resources. With heterogeneous capital goods, there may be a total loss in equipment suitable only to the production of tanks and partial loses with capital that is only slightly appropriate to whatever private goods and services households prefer. The result will be a temporary reduction in output and employment. Fortunately, as labor shifts and appropriate capital goods are constructed, real output should recover.

Notice that this equilibrium approach to the Austrian theory is symmetrical. There is structural unemployment in both the "boom," and in the "bust." Both the implementation of the inflation tax/government expenditure scheme, and its repeal, result in structural unemployment, losses for specific capital goods, and a transition period where output is depressed.

Suppose that political story is slightly different. The politicians implement a very low inflation tax. They purchase only a few tanks. Finding that low inflation tax creates little political opposition, they try a slightly higher tax and purchase more tanks. The tank industry is gradually expanding. As resources shift from various private goods and services towards tanks over the years, the somewhat higher structural unemployment and lower level of output becomes the new normal.

Once inflation reaches 10 percent, the people rebel. They begin listening to those who claim that inflation is everywhere and always a monetary phenomenon. They begin to doubt the stories of the politicians that prices are rising due to growing greed in the private sector. Or perhaps they no longer value the tanks.

The politicians suddenly decide that inflation is politically unacceptable. They stop at once. The tank industry, after years of slow growth has grown quite large. Suddenly, it drops to zero. Since the inflation tax has dropped to zero as well, there is a substantial increase in the real demands for various private goods and services. Still, this sudden large change in the composition of real demand involves a substantial increase in structural unemployment. Combined with the complete or partial losses associated with capital goods more or less specific to the tank industry and the gradual build up of capital goods more appropriate to the production of private goods and services, the transitional decrease in output and employment looks sudden and large.

If the analysis is shifted from a static to a growing economy, there are many complications that must be added. The demand for real money balances is presumably growing. The government can issue money without there being price inflation. But rather than deal with all of those complications here, consider just the following change in the analysis. Suppose that the gradual build up in the inflation tax never required any reduction in the production of private goods and services or in the employment of labor in those sectors. Instead, real and nominal expenditures on private goods and services simply grew more slowly and employment in those areas grew more slowly. Some new entrants into the labor force began to produce tanks. Some of the new capital goods being produced were devoted to tanks. During the entire period of growing inflation, the rest of the economy is expanding, more people are hired, and more capital goods are produced. The composition of final demand and output, and of composition of the capital stock and the allocation of labor between sectors are all changing over time, but it is sufficiently gradual that there is never any absolute decrease in the demand or production of the private goods and services being sacrificed to pay the tax.

And now, suppose the voters demand an end of inflation, and the tank industry suddenly collapses. While the gradual build up of the tank industry and the gradually rising inflation tax simply implied that employment, investment and production in the private sector grew less than they would have, the shut down of the tank industry requires that workers find new jobs. Rather than simply not building fewer or no capital good specific to the tank industry, existing capital goods specific to tank production become worthless.

In other words, there is no symmetry in adjustment costs if the time taken for the adjustment isn't symmetrical. Consider the opposite scenario. Suppose their was a crash program to build up a tank force funded by inflation. And then, the inflation tax was gradually reduced. The workforce in the tank industry shrinks by attrition. Tank specific capital goods are not replaced. As resources are freed up to produce private goods, the inflation rate is lowered, and the private expenditures can expand because their is less build up nominal balances to maintain real balances. In that situation, there could be large reductions in the real demand for private goods and services and structural unemployment and losses in capital goods specific to those industries during the buildup. On the other hand, the gradual end of the inflation tax, there could be little obvious disruption in the transition. (Of course, the taxpayers give up private goods and services to get additional tanks.)

The Austrian theory has not been about tanks. While the most abstract approaches, about money entering the economy at one place and impacting relative prices and so output, is consistent with the story about tanks, generally, the Austrian theory has focused on interest rates, saving and investment.

Suppose that rather than using the revenue created from the inflation tax to purchase tanks, the government provides a subsidy for the provision of loans. Think of it as a subsidy for production and sale. The private sector generates a loanable fund market with the interest rate being the price of those loans. Lenders receive a payment from the government equal to some fraction of the interest rate. As usual with such a subsidy, the lenders are willing to supply more loans. The equilibrium interest rate paid by the borrowers is lower. While the amount lenders receive from borrowers is less, the equilibrium net interest rate the lenders receive is higher--what is paid by the borrowers plus the subsidy. The equilibrium quantity of loans is higher.

To the degree that an inflation tax on real money balances generates a revenue that is used to subsidize the provision of loans, a persistent shift in the allocation of resources is possible. Such a tax and subsidy scheme can be permanently sustainable. If it is instituted only gradually, then the transitional disruption caused by the change in the allocation of resources could be small, and more or less nonexistent in the context of a growing economy. If, however, the inflation tax became politically unacceptable, and it suddenly dropped, then the readjustment as interest sensitive industries sharply contracted could be wrenching.

Finally, can the revenue from an inflation tax be shifted to borrowers, not by providing lenders with a subsidy for the loans made, but rather by simply lending the funds created by the central bank out in competition with other lenders? I believe that the answer is yes, and that this equilibrium process has been often mixed in with the disequilibrium process described in my previous post.

In my view, the disequilibrium process--an excess supply of money generating an increase in the real supply of credit--is likely too ephemeral to generate any significant malinvestment. On the other hand, the equilibrium process by which an inflation tax on real money balances is used to subsidize lending, can be persistent. And if it is gradually introduced, and then suddenly removed, the result can be the sudden appearance of significant structural unemployment and what it hindsight appear to be inappropriate capital goods.

The problem with the equilibrium process is that the base of the inflation tax is the monetary base. Before the current crises, the monetary base was approximately $800 billion. The inflation "tax" was perhaps 5 percent. (The price inflation rate was 2 percent and the demand for real balances was growing about 3 percent.) That generates a $40 billion revenue. Nominal income is currently $14 trillion. Gross investment is about $1.6 trillion. While a $40 billion tax and subsidy scheme almost certainly impacts relative prices, the composition of output, and the allocation of labor and other resources, even reducing this "tax" all the way to zero would seem unlikely to generate significant adjustment costs.

In my judgment, both the disequilibrium and equilibrium processes are unlikely to generate significant malinvestment. I am not saying that there would be no malinvestment. In my judgement, liquidation of malinvestments generated by monetary policy do not significantly contribute to the decrease in production and increase in unemployment in recessions.

It is my view that too many single family homes were produced in the U.S. during the naughties. I think the structural unemployment and the need to construct appropriate capital goods to replace some that were specific to housing construction is a significant source of unemployment and may have absolutely reduced the productive capacity of the economy. But I don't believe that persistent excess supplies of money in the early naughties are a plausible source of the problem. And there certainly has not been an intentional decrease in the inflation tax.

Austrian Business Cycle Theory 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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