Thursday, October 22, 2009

Boettke and Horwitz on Hayek's Monetary Theory

On the Austrian Economist Blog, Pete Boettke and Steve Horwitz have both had posts on Hayek's monetary theory.

Boettke included Garrison's graphical representation of the Austrian Business Cycle Theory.

This simple graph is very consistent with my basic approach to macroeconomics. More saving, a decrease in the natural interest rate, and a shift in the composition of demand from consumer to capital goods. And while I never draw anything like the "stages of production" graphic in the upper left, I do think of added production of capital goods as using current resources to make more provision for the more distant future.

Further, my past research in pure inside monetary systems, where all monetary liabilities are matched by some kind of asset, makes it natural to follow the Wicksellian approach. Monetary disequilibrium involves a deviation of "the" market interest rate from "the" natural interest rate. The situation here shows the market rate falling below the natural interest rate, presumably due to an excess supply of money. The quantity of money is greater than the demand to hold money.

In the spirit of thinking about alternative assumptions, rather than comparing the disequilibrium resulting from the lower market rate to what would have happened to the natural interest rate if there were an increase in saving, what if the comparison was to what would have happened if the investment curve had shifted to the left. That too would result in a lower natural interest rate, but the shift in the composition of demand would be from capital goods to consumer goods, and the "structure of production" would shorten.

Why is there a tradition of treating the disequilibrium market interest rate as being a false signal of a rightward shift of the supply of saving schedule and of a switch from present consumption to future consumption, instead of a false signal of a leftward shift of the investment schedule?

In the diagram, there is an arrow that heads outside of the production possibilities frontier, representing the level of production of consumer goods and capital goods implied by saving and investment generated at the disequilibrium market interest rate. The curve then shifts towards additi0nal production of capital goods relative to consumer goods, before heading into the interior. Why? Why doesn't it circle around the other way? Why doesn't the monetary disequilibrium shift resources towards the production of consumer goods relative to capital goods?

One final point about the graphic. It focuses on "the" interest rate. This is a common simplifying assumption, and one that I have often made. The events of the last few years, however, have made me very sensitive to the reality that we have many interest rates, and that it is possible for low risk, short term interest rates to fall, while long term, high risk interest rates rise. It is not clear that such a change (or the reverse) can be usefully analyzed using Garrison's graphic.

Boettke then describes three basic ideas that are central to his understanding of money-macro; ideas central to the "Austrian" tradition.

  1. Money is non-neutral

  2. Economic adjustments are guided by relative prices

  3. Capital structure in a modern economy consists of combinations of
    capital goods that are both heterogenous and possess multiple-specific uses

The conventional view in monetary theory is that money is not neutral in the short run, but neutral in the long wrong. The conditions necessary for superneutrality are rather implausible, and so, a better way to state the conventional view is that money is less neutral in the short run and more neutral in the long run. And really, this is just a claim that the impact of sticky prices and wages wash away in the long run. There many be regulatory and even institutional rigidities that don't necessarily go away.

In my view, the Austrian Theory of the Business Cycle is consistent with money becoming more neutral in the long run. The nonneutrality in the short run is when the malinvestments are generated, reflecting what are temporarily profitable opportunities. As these temporary changes caused by the nonneutralities dissipate over time, what appeared to be profitable opportunities are revealed to be malinvestments.

In a world of sticky prices and production for the future, I am less and less comfortable with the assumption that economic adjustments are guided by relative prices. We all know better than to assume that current prices (relative or otherwise) perfectly reflect current scarcities and evaluations. The prices may well be wrong--generating surpluses or shortages that will result in revisions to those prices. And, further, it is expected future prices that are going to generate the profits or losses that provide the incentives to adjust production.

The concept of quasi-rents, developed by classical economics, implies heterogeneous capital goods. Changes in the composition of demand and so the allocation of resources, including labor, imply structural unemployment. Globalization and free trade apologetics emphasize the benefits of the redeployment of labor, but recognize the cost implied by the loss in value of industry specific skills. That physical capital, along would human capital, would similarly lose value can hardly be a great insight.

However, the highly abstract growth theory developed by Solow ignores any heterogeneity of capital goods. Returning to the saving and investment graphic and production possibilities frontier for the production of capital goods and consumer goods above, consideration of specific capital goods make it clear that "equilibrium" shifts in these curves and along that frontier involve similar transition costs as the exploitation of opportunities created by expanded international trade.

That monetary disequilibrium might cause related problems, should be obvious, but most monetary economists have been too blinded by excessive abstraction to consider this. While the proper degree of abstraction surely depends on the specific problem at hand, it is a mistake to allow abstraction to mask what could be a serious problem--malinvestment.

Boettke quotes Hayek and asks a question. Hayek writes:

"The impossibility of dealing expressly with changes in the velocity of circulation so long as this assumption was maintained served to strengthen the misleading impression that the phenomena I was discussing would be caused only by actual changes in the quantity of money and not by every change in the money stream, which in the real world are probably caused at least as frequently, if not more frequently, by changes in the velocity of circulation than by changes in the actual quantity."

Boettke asks:

Is this misleading impression what is behind the disagreements on this blog and elsewhere concerning monetary equilibrium theory? Did Mises-Hayek ever adequately correct the "misleading interpretation" in their respective works?

I have little doubt that the amateur "Austrian" economists recruited through Rand, the libertarian movement, Libertarian Party, Ron Paul, and hard money investing, are led astray by failing to remember, "ceteris paribus." On the other hand, there are a good number of good macroeconomists who favor a fixed nominal quantity of money or else a 100% reserve gold standard. Presumably, they aren't making some simple error.

I don't think that velocity is a helpful concept here. Ceteris paribus, what is the impact of an increase in the supply of a good? The key ceteris paribus assumption is that demand is unchanged. Price adjusts, quantity supplied and demanded adjust, and the end is a new price and quantity.

What happens when the quantity of money increases, given the demand to hold money? In the end, prices rise and the real quantity of money returns to the unchanged real demand. Malinvestments might appear during the adjustment process.

But if we consider a simultaneous increase in the supply and demand for some good, ignoring the increase in demand would be absurd. Further, the market process is unlikely to be characterized well by considering first a complete adjustment to the increase in demand, and then, from that "equilibrium," a subsequent increase in supply. The end might be the same, but some of the gyrations in prices would be an illusion.

Similarly, considering the impact of an increase in the demand for money, and that the economy has settled into a new equilibrium with lower prices and a higher real quantity of money and then considering what happens subsequently if the quantity of money rises will hardly do. If both changes occur at the same time, then the impacts of both will be occuring together. What type, if any, malinvestments would occur should be specific to the scenario where both the quantity of money and the demand to hold money are changing together.

Steve Horwitz gives the following quote from Hayek

"I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.”

(Hayek Scholar Greg Ranson found this in a book newly translated from Spanish, Conversations with Great Economists: Friedrich A. Hayek, John Hicks, Nicholas Kaldor, Leonid V. Kantorovich, Joan Robinson, Paul A.Samuelson, Jan Tinbergen by Diego Pizano.)

This quote suggest that Hayek considered decreases in the quantity of money undesirable. At least, Friedman's view of the Depression is that it was the decrease in the M2 measure of the quantity of money that resulted in the disaster. However, Friedman's view is that the decrease in M2 was caused by the Fed's failure to expand the monetary base enough to offset the drop in the money multiplier. And so, this shows that Hayek would reject the doctrine no increase in the monetary base is ever desirable.

In a follow up post, Horwitz presents a table where he suggests four possibilities--

  1. The Fed allows MV to fall 30% and Hoover discourages wage and price cuts. This leads to a decade long disaster with a 30% drop in production and a 25% unemployment rate.
  2. The Fed allows MV to fall by 30% and wages are prices are more or less flexible as in 1920-1921. The result is a recession like 1920-1921. The unemployment rates rises to 12% and the recession ends in two years.
  3. The Fed keeps MV stable and wages and prices are sticky. Mild but long recession because sticky prices and wages slow the reallocation of resources that had been misallocated during the boom of the twenties.
  4. The Fed keeps MV stable and wages and prices are more or less flexible. A short and mild recession is caused by the reallocation of resources that had been misallocated during the boom of the twenties.

(These are paraphrases of his statements and may include a bit of my own interpretation. Follow the link to find his table.)

I think Horwitz's four possibilities do a good job of characterizing the situation when there is a misallocation of resources that needs to be worked out overlaid with a drop in nominal expenditure due to a decrease in the quantity of money or increase in the demand to hold money.

Personally, I doubt there was a significant overhang of malinvestments generated by Fed policies in the twenties, but entrepreneurial error and a need to redeploy resources are normal elements of the process of creative destruction. Price floors or ceilings aimed at keeping prices from adjusting to clear markets are counter productive at any time, and informal price controls "enforced" by threats are at best only a marginal improvement over fines, imprisonment, or execution. As for the New Deal, it was full of destructive, anti-competitive policies that should be expected to reduce the productive capacity of the economy. Adjustment to those policies almost certainly would involve structural unemployment and certainly would involve additional institutional unemployment as well.

One element of political economy that should be considered is whether Hoover's jawboning would have even occurred if the Fed had kept nominal expenditure from falling. Would Roosevelt have even become president, and if he had, would the N.R.A. scheme of universal price floors been instituted?

Finally, regardless of whether or not there was significant malinvestment in the twenties and what might have caused it, the U.S. today requires a major redeployment of resources away from the production of single family homes. Trying to "cure" the "problem" of falling home prices by promoting labor union organization in the construction trades would be counterproductive to say the least. In my view, if the Fed would have kept nominal income on its previous 5% (or even an improved 3%) growth path, many of the undesirable economic policies of the Obama administration could have been avoided.


  1. In his paper "Hayek versus Keynes on How the Price Level Ought to Behave," George Selgin claims that before '31, Hayek held the view that any expansion of the money supply is undesirable. However, after '31 Hayek's views began to resemble those of proponents of monetary equilibrium. In 1933, Hayek wrote an article called "Saving" for the "Encyclopedia of the Social Sciences," and Selgin identifies it as the earliest published record of Hayek's modified position:

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

    Many amateur Austrians believe that any expansion of the money supply will create malinvestment by "distorting" relative prices. Whoever receives the new money early will have additional buying power at prevailing prices; these money "injections" will have a tendency to draw resources away from equilibrium. The misallocation created by the monetary expansion is then unsustainable, because relative prices have a propensity to adjust back toward equilibrium (i.e. money is neutral in the long run). In this view, constant and increasing monetary expansion is required to sustain malinvestment, and central banks are all too willing to accommodate the illusory prices to avoid a bust.

    I am highly sympathetic to this view, but I would contest the claim that monetary expansion, and its associated "injection effects," must always create malinvestment. While it is true that monetary expansion changes relative prices, it does not follow that any such change is a distortion. If a decline in spending on consumption is matched by an rise in investment spending, then, in my opinion, there is no "distortion." In fact, prices would be changes exactly as they should -- turning increased savings into investment.

  2. Lee:

    Thanks for the citation.

    I think malinvestment is likely when there is a regime change and also when the central bank makes an error under a regime and entrepreneurs make the same error.

    With a regime of free banking, malinvestments occur when entrepreneurs make errors. Of course.

  3. Does malinvestment include investments that should have been made but weren't? I usually assume so, but many people talk as though it only includes investments that shouldn't have been made but were. I think this blinds some to the kind of malinvestment that occurs during deflation, because it primarily is in the form of investments that should be made but aren't.

  4. Lee:

    I think malinvestment usually means that the wrong capital goods are actually produced. It is a type of investment, but somehow wrong. Producing additional consumer goods instead of any type of capital good would not be investment. And producing nothing (or maybe leisure) is better described as unemployment rather than malinvestment.

  5. "The curve then shifts towards additi0nal production of capital goods relative to consumer goods, before heading into the interior. Why? Why doesn't it circle around the other way? Why doesn't the monetary disequilibrium shift resources towards the production of consumer goods relative to capital goods?"

    Because Austrian capital theory dictates that lower interest rates direct capital investment towards the higher phases of production; towards more capitalistic and indirect methods. This is because there is a relative fall in the price of consumer goods with respect to the producer goods (both could rise, but the latter would rise at a faster pace). A given amount of capital does not yield constant output; it can be rearranged in different orders reflecting different degrees of roundaboutness, which will yield different input-output results. The lower interest rates also makes long-term durable capital goods investments more feasible, due to their physical nature (not incrementally accumulated).

    This is not to say that there won't be, or can't be, additional investment in the lower phases of production. Nor is it saying that there can't be more direct and efficient methods of production. It merely states that the most direct and efficient methods of production are employed first, the same way that, in Ricardo's analysis of rent, the most fertile land is employed first.

    The marginal productivity of capital is not only determined by the capital goods themselves, but by the allocation of capital towards remoter (or direct) methods of production.

  6. I am familiar with Austrian capital theory.

    If you look at the supply of saving and demand for investment diagram, when the market interest rate falls below the natural interest rate there is an increase in the quantity of investment demanded and a decrease in the quantity of saving supplied. A decrease in the quantity of saving supplied is an increase in the demand for consumer goods.

    Whether the increase in the demand for goods of the higher order is greater than the increase in the demand for goods of the lower order depends on the slopes of the curves.

    The assumption made by Austrians is that investment demand is more interest elastic than saving supply (and so the demand for consumer goods.) Actually, the stories told often suggest a perfectly inelastic supply of saving with respect to the interest rate.

    This may be true. But it isn't necessarily true. It doesn't follow from the nature of round about methods of production.

    If there is an increase in the supply of saving (like lower time preference) and the supply of saving shifts right, then that is an increase in saving supply and decrease in consumption demand. The lower interest rate lowers the quantity of saving supplied and raises consumption demand at the same time it raises the quantity of investment demanded. Because this is a dampening of the increase in the amount saved and decrease in consumption, the total effect is a shift of demand away from goods of the lower order and towards goods of the higher orders.

    But, if the market interest rate falls below the natural interest rate, there is an increase in the demand for goods of both orders, and nothing in theory that shows that the increases the demand for goods of the higher orders more than lower orders. It all depends on elasticities.

    By the way, I really think the production of durable goods should be more central to thinking about malinvestment, and the higher and lower order goods story should be secondary. Hayek, for example, does cover all the possibilities about investment. But I think the more conventional "durable goods" story (again, covered by Hayek) should go to center stage.

    Also, it is very important to remember this is all about plans. Allocating existing resources to produce for the nearer or more distant future. The pedigree of the existing resources aren't important.

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