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.)