Malinvestment and Monetary Equilibrium

Murray Rothbard and his followers have claimed that any increase in the quantity of money that is matched by bank lending (rather than backed by gold) leads to malinvestment. Joe Salerno's critique of Larry White was superficially about what Ludwig Von Mises thought, but really was about that substantive issue. Along with Salerno, Walter Block, De Soto, and Bob Murphy take this view.

My view is that only an excess supply of money can possibly lead to malinvestment. If the quantity of money and supply of credit rises to match an increase in the demand to hold money, the consequences are the same as an increase in the supply of credit due to an increase in the demand for bonds.

Austrian economists of the monetary equilibrium variant, which includes Larry White, Steve Horwitz, Roger Garrison, Jerry O'Driscoll, (and George Selgin, though he does not claim affiliation with the "Austrian School,") agree with this general conclusion. Their usual approach focuses on a scenario where an increase in the demand to hold bank deposits or banknotes is an increase in saving. Households reduce consumption out of current income and accumulate bank liabilities. The banks expand their lending, issuing new money to borrowers. The monetary equilibrium theorists argue that the increase in the quantity of money just offsets the decrease in velocity, and so there is no addition to the stream of monetary expenditures to cause malinvestment.

The Rothbardians, however, insist that the fiduciary media (money issued to fund bank loans,) still distorts relative prices because it doesn't go exactly to those individuals who demanded more money by reducing their monetary expenditures. They accuse the monetary equilibrium theorists of "macroeconomic thinking."

I side with the monetary equilibrium theorists in this debate. The element of truth in the Rothbardian argument is that there is little doubt that the process of money creation does impact relative prices. Where he and his followers go wrong is in assuming that any changes in the pattern of relative prices resulting from an increase in the quantity of money that matches an increase in the demand to hold money is usefully characterized as malinvestment.

The best way to see this is to compare the effects of a change in the demand for bonds with a change in the demand for money. Following the conventional approach, I will start with a scenario where there is an increase in saving by households. Some particular households spend less of their incomes on consumer goods and services. Those households save. Savings in aggregate increase as well. This saving could take the form of purchasing bonds or it could take the form of accumulating money.

First, suppose that some households increase saving, reducing their consumption out of income and instead use the money they earn to purchase corporate bonds. The demands for the particular consumer goods they would have bought are lower than otherwise. Those firms that would have sold those consumer goods earn less. They demand fewer resources, including less labor. This implies a decrease in the incomes earned by the workers and other resource owners.

The increase in the demand for corporate bonds causes their prices to rise, and their yields to fall. This is a decrease in the market interest rate. This creates a signal and provides an incentive for firms to purchase additional capital goods. Suppose the firms that purchase the capital goods fund them by issuing new corporate bonds.

Then, the firms that sell the corporate bonds use to the funds to purchase capital goods. The firms selling the capital goods earn more money. These additional revenues result in greater profits. The greater profits give a signal and provide an incentive to add capacity to the production of capital goods. The allocation of finance and the demands for resources, including both labor and existing capital goods, will be directed towards producing additional capital goods. The resources needed to produce those capital goods must be purchased. The implied increase in demand for them raises the incomes of the workers and other resource owners.

However, the demands for those resources that had been used to produce consumer goods have fallen. The decrease in demand by the firms producing consumer goods and the increase in demand by the firms producing additional capital goods offset. While some workers and resource owners likely earn lower incomes, other workers and resource owners earn higher incomes. Labor and other resources are shifted from the production of consumer goods to the production of capital goods.

Using the terminology of Austrian economics, the structure of production has lengthened. More resources are devoted to producing goods of the higher orders. Fewer resources are devoted to producing goods of the lower orders. More resources are devoted to producing consumer goods in the more distant future. Fewer resources are devoted to producing consumer goods for the near future. According to some Austrians, the lower market and natural interest rate that first appeared in the bond market play a more central role in the structure of production, as the gap between the prices of resources and the prices of products shrink.

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.

Further assume that the banks expand lending by purchasing corporate bonds, the exact same corporate bonds that the households purchased in the previous scenario. The market interest rate decreases exactly in the same way as before. The added demand for corporate bonds raises their prices and lowers their yields. This creates the exact same signal and incentive for firms to purchase additional capital goods. As before, the firms purchasing the capital goods finance the purchase by issuing new corporate bonds.

Those selling those same capital goods receive greater profits. The increased profitability of producing additional capital goods creates a signal and incentive, exactly as before, to direct more financing into this field of endeavor, and so raises the demand for labor and existing capital goods to expand the production of capital goods.

Using Austrian terminology, the change in demands, away from consumer goods and to capital goods, and the decrease in the market interest rate, results in as shift in the structure of production away from lower order goods to higher order goods. Less production is directed towards the production of consumer goods in the near future and more towards the production of consumer goods in the more distant future. Again, the gap between the prices of resources and their products shifts to reflect the new lower interest rate.

This particular account has made heroic simplifying assumptions regarding financial markets. In the first scenario, the households purchased corporate bonds, resulting in a lower market interest rate, motivating firms to purchase new capital goods by issuing new corporate bonds. Corporate bonds are treated as homogeneous. In the second scenario, the households accumulated money balances, and the banks purchased the exact same corporate bonds as in the previous scenario. The added demand for those bonds by banks also lowered the market interest rate, which motivated firms to buy new capital goods and sell new corporate bonds, just as before.

More realistically, the households purchase some kind of asset, which tends to raise their prices and lower their yields. Those they purchase from use the money they receive to purchase something else. They may purchase additional consumer goods. The increase in the supply of saving has resulted in lower interest rates, both the natural and the market interest rate, and this results in a decrease in the quantity of saving supplied.

However, it remains true that the lower interest rate will also increase the demand for capital goods. It raises the expected present value of profits from the sale of consumer goods in the future, which makes the expected profit from purchasing capital goods higher. This is the increase in the quantity of investment demanded due to the lower market and natural interest rates.

The firms that actually purchase the capital goods may finance these investments any number of ways, and only one of them is to issue new corporate bonds. Firms might instead borrow from a bank, issue stock, sell off financial assets previously accumulated, or even fund the project out of current cash flow. It is unlikely that the particular firms that invest will fund their activities by selling bonds to the particular households that save, but it doesn't really matter.

Similarly, while banks do purchase corporate bonds sometimes, they usually make commercial or consumer loans. And the usual way that banks expand loans is by lowering the interest rate they charge and then supply the amount of loans that are demanded. Those particular firms and households that borrow from banks are not borrowing from other sources. This decreases the supply of those other securities, raising their prices and reducing their yields. The increase in the supply of credit by banks lowers market interest rates across financial markets.

The increased borrowing motivated by the lower interest rate charged by banks implies changes in consumption and investment by the households and firms obtaining the loans. But the changes in the interest rates on other financial assets also motivate changes in consumption and investment as well. Some of the households that were holding stocks or bonds, may respond to the higher prices and lower yields by purchasing consumer goods. Some firms may respond to the higher prices and lower yields on bonds by an new issue of bonds to fund the purchase of capital goods. Some firms my respond to the higher stock prices by a new issue of stock to purchase new capital goods.

It is the role of financial markets to facilitate such transfers of funds between and among households and firms. It is certainly true that the particular assets that households accumulate will have some effect on the pattern of expenditures that results, but the general notion that the accumulation of those assets implies an increase in the supply of credit, and lower market and natural interest rates remains true. By assumption, the demand for consumer goods fell. Households reduced their purchases of consumer goods and services initially. The lower market and natural interest rate results in increased demand for various goods and services, including both consumer goods and capital goods. These changes depend on the interest elasticities of demand for those goods. However, the net effect is a shift from consumer goods to capital goods. There remains a shift in the structure of production from production of consumer goods in the nearer future to the production of consumer goods in the more distant future.

As long as the banks expand the quantity of money no more than the increase in the demand to hold money, and so their addition to the supply of credit is no greater than what would have been the addition to the supply of credit if the households had instead spent the money on some financial asset, the effect on the market interest rate is the same. In both situations, the market interest rate falls with the natural interest rate.

Remarkably, some amateur Austrians of the Rothbardian persuasion have responded to these sorts of explanations by arguing that perhaps the increase in the demand for money was not due to a decrease in the demand for consumer goods and added saving, but rather due to a decrease in the demand for other assets. It is actually a bit odd that so much of the debate has been about saving by accumulating money balances and what happens if there is or is not an expansion in the quantity of bank-issued money to match that increase in the demand to hold money.

Suppose households were using income to purchase consumer goods and services and also were saving by using income to purchase corporate bonds. The firms are issuing and selling the corporate bonds to fund the purchase of capital goods.

The households do not change their saving and continue to use income to purchase consumer goods and services exactly as before, but rather than use their saved funds to purchase corporate bonds, they accumulate larger money balances.

This decrease in the demand for corporate bonds will result in a lower price and a higher yield for them. The market interest rate will increase. Since saving has not changed, there has been no change in the natural interest rate. Households save the same portion of income as before, they are just saving by accumulating money rather than corporate bonds. The market interest rate rises above the natural interest rate.

Suppose that instead the banks expand the quantity of money by purchasing the exact same corporate bonds that the households would have purchased. The households continue to spend the same amount of income on consumer goods and services as before. They save exactly as much as they were saving before. They save by accumulating money balances rather than purchasing corporate bonds. 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. 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.

This scenario also relates to the effects of a temporary increase in the demand for money due to disturbed conditions discussed in my previous post. To some degree, the change in the demand for money is exactly as described above. Households are worried about disturbed conditions, and rather than saving by accumulating financial assets, they save by accumulating money. To the degree that banks purchase the assets with newly created money, the market interest rate remains unchanged along with the natural interest rate.

Further, it is possible that rather than simply impacting the allocation of their flow of saving between money and other assets, unsettled conditions may result in households selling off parts of their existing portfolios of assets to accumulate more money. To the degree banks issue new money and purchase those assets, the market interest rate remains unchanged with the natural interest rate.

Of course, banks may not purchase the exact same assets that households want to sell. But as explained above, these financing changes tend to have balancing effects on credit markets. Those who borrow from banks don't borrow by selling financial instruments, like commercial paper. Finance companies have less loan demand and so less need to sell corporate bonds. Generally, the yields on the financial assets that households are selling rise, and the interest rate that banks charge fall. But these are offsetting impacts on "the" market interest rates and the allocation of resources between the present and future.

Of course, it is possible, even likely, that the response to unsettled conditions will include an increase in the supply of saving. Worries about unsettled future conditions may lead households to reduce current consumption. Further, worries about future economic conditions might reduce the demand for investment. Firms will become more uncertain about what consumers will be willing to pay for various products at future dates, and so be less inclined to purchase capital goods and any given level of interest rate. The natural interest rate almost certainly would fall. And so, the result isn't simply a change in what type of assets households want to hold, either money or stocks or bonds, and how firms will fund purchases of capital goods, whether through bank borrowing or the issue of stocks and bonds. The market interest rate needs to fall with the natural interest rate.

In highly abstract terms, the lower natural interest rate and lower loan rate by banks will tend to result in an increase in the demand for various goods depending on their interest elasticities of demand. These could be consumer goods or capital goods. Because unsettled conditions have lowered the demands for both consumer goods and capital goods, the effect on the allocation of demand between those goods is ambiguous. It is certainly not the case that an expansion of the quantity of money that meets an increase in the demand for money, even at a lower market and natural interest rate, will necessarily shift the allocation of resources away from the production of consumer goods to the production of capital goods.

For example, suppose that unsettled conditions causes people to reduce purchases of new cars. The old cars will have to suffice for a time until conditions improve. The banks lower interest rates so that people less worried about economic conditions borrow money to purchase cars. This reduces the need to shift resources away from the production of cars.

Suppose firms are worried about current economic conditions and decide to postpone purchases of new computer equipment. The banks lower interest rates, and some firms that would have sold commercial paper obtain bank loans. The decrease in the supply of commercial paper results in higher prices and lower yields. Some investors in commercial paper switch to corporate bonds. The corporate bond prices rise and their yields fall. The lower yield on corporate bonds motivates some firms to go ahead and purchase the computer equipment as before. This reduces the need to shift resources away from the production of computer equipment.

Will the pattern of expenditure be unchanged? No. But 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.