Thursday, April 15, 2010

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.


  1. I had been teetering on this realisation for a while, and your last two posts have just shoved me off the edge.

    But what of an injection of money not in the form of new loans, but instead just an increase in money balances for some particular industry?

    Insofar that new money balances reduce the demand for loans, interest rates will fall and the new money will distort the patterns of demand, i.e. spending of the old money. However, what if the new money balances do not reduce the demand for loans and, therefore, do not lower interest rates?

    In any case, on another matter, it seems to me that this common Austrian misunderstanding of injection effects is partly responsible for the objection to fractional reserve banking.

  2. Bill:

    Suppose we tried to trace the passage of new shares of IBM stock through the economy. IBM issues the new shares to people who pay, say, $60 each for them. IBM's assets rise in step with its liabilities, so the share price does not change. The purchasers get the shares, but they also lose $60 for each share they buy. Nobody's net worth is affected, and the story ends there.

    Now the fed issues a new dollar. The Fed's assets rise in step with its liabilities, so the value of the dollar does not change. The receiver of the dollar gets the dollar, but loses the $1 bond he sold for it. Nobody's net worth is affected, and the story ends the same way as the IBM case.

  3. When the Fed purchases a bond, there is no guarantee that the person selling the bond wants to hold money instead. Money serves as medium of exchange. People will accept it even when they intend to spend it.

    Generally, when a person purchases IBM stock, there is reason to believe they want to hold the stock.

    There is no particular reason to believe that central banks limit their issue of money so that its value is not less than the assets they hold.

    Since corporations are owned by the stockholders, issuing too much stock so that it is worth less than the assets it used to purchase reduces the wealth of the people who own the stock and who control the firm.

    In my view, treating currency as an equity claim against the government and money holders as if they the owners of the government is a mistake.

    For example, currency holders cannot vote, with votes in proportion to money holdings, to liquidate the government, with each money holder getting a proportional share of government assets, which would include a more or less unrestricted power to tax the citizens.

    Shareholders of IBM can vote to liquidate IBM. While IBM doesn't have any power to tax, they can divy up the assets it actually has.

    The only similarity between currency and shares is that currency generally pays no interest and shares don't have to pay dividends. The differences are much greater than the similarities.

  4. Lee:

    If the government just purchased the drill presses, the analysis is a bit different. Suppose, however, that they purchase GM cars. Some of those who would have purchased GM cars instead purchase Fords. They don't have any of the newly issued money. They use their "old" money to purchase Fords because the prices of GM vehicles are higher.

    Assuming the supply of GM cars are not perfectly inelastic, more will be produced. And more Fords will be produced too if the supply of Fords aren't perfectly elastic.

  5. Bill:
    "When the Fed purchases a bond, there is no guarantee that the person selling the bond wants to hold money instead."

    There is exactly such a guarantee, since the trade is voluntary. The bond seller must have wanted the dollar more than he wanted the dollar's worth of bonds, or he would not have traded.

    Of course the Fed can, if it chooses, sell a dollar bill in exchange for a bond worth only $.99. Huge numbers of eager bond sellers will jump at this offer, just as they would if IBM offered shares for less than what they are worth. Conversely, if the Fed offered its dollars in exchange for bonds worth $1.01, few if any bond sellers would be interested. The same would happen if IBM overpriced its shares.

    If the Fed sells dollars too cheap, dollars will lose backing and lose value, while if they sell dollars too expensive, dollars gain backing and gain value. Same for IBM shares.

    "For example, currency holders cannot vote,...Shareholders of IBM can vote to liquidate IBM."

    That is beside the point. Many financial securities have little or no voting rights, but nobody claims that those financial securities thereby cease to be valued on the same principles as any other equity claim.

    If paper money is not an equity claim against its issuer, and if it is valued, as the textbooks say, simply because people demand it while its supply is limited, then there should be some historical example of paper money (of positive value) that was issued by an entity that held NO assets against it. If any critics of the backing theory know of such a money, they have been remarkably silent about it.

    A major virtue of the backing theory is that there is no need for any 'special' theory of money. Paper money has value for the same reason that any financial security has value--it is backed by the issuer's assets.

  6. Mike:

    You don't get it.

    The money services as medium of exchange. There is something the seller of the bond wants more than the bond. But there is no reason to believe that it is necessarily to add to the share of wealth held in the form of money. He accepts the money intending to spend it.

    Stock doesn't serve as medium of exchange.

  7. Bill:
    A guy wants a $1000 drill press. He has a $1000 bond. He goes to a bond auction to sell his bond for $1000 in cash to buy the drill press. The buyer of that bond might be a private individual, in which case the bond is bought with existing cash, or the buyer might be the Fed, in which case the bond is bought with newly-printed cash. If the Fed is the buyer, the Fed's assets and liabilities both rise by $1000. If that extra $1000 in cash is not wanted for circulation, then the next time a $1000 bond is offered for sale at an auction, it will be bought with that $1000 in cash, rather than by new cash just printed by the Fed. The Law of the Reflux prevents unwanted cash from remaining in circulation.

  8. I know at least one person very interested in economics (has a blog about it) who seems to think you're saying that injection points are not important and not special. He linked me here, and after carefully reading what you're saying, you're really just warning against treating the new dollars themselves as being special. I think you might want to clarify.

    After the red money is spent the first time, the receiver of the red money doesn't need to distinguish at all between red and green. To buy a $2 hot dog, he can spend 2 red, 2 green, or 1 red and 1 green. In that sense, the red and green dollars are identical after the first purchase. However, this doesn't change the fact that the red money itself was the *cause* of the newly increased bank account of the first receiver, and who that receiver is will ultimately determine how the money flows into the economy.

    For instance, Intel is unlikely to take a new sum of money and buy mining equipment, just as US steel is unlikely to start purchasing silicon wafers and clean rooms. The new red money's injection point swells the call to resources for somebody in particular. The "who" is important because it determines what that new call to resources is used for. So you can't track the red dollars through the economy and explicitly say that those are the ones that represent demand that wouldn't have existed (hot dog example above), but you can know that there is new demand in exactly the proportion of new red dollars to existing green.

    Sadly, it is completely uncomputable to know what proportion of the demand for any given good is due to the new money, which makes it impossible to track. However, the new demand must exist, must increase prices, and must be dependent on the injection point, because that injection point decides how to spend it. That is the point of the Austrian argument, and that has not been refuted here at all. The moronic interpretation of the Austrian argument, that the new physical dollars continue to represent new demand even after the injection, has been refuted, but I hope not many people would ever take that interpretation seriously. When Austrians talk about new money, they mean the new call to resources, which temporarily exceeds resources available in the economy until prices change to equalize them.