Sunday, April 21, 2013

Another "Austrian" Critique of Market Monetarism: Part 1

Shawn Ritenour provides a critique of Market Monetarism on   He charges:

Market monetarist theory and policy is unsatisfactory primarily because Market monetarists use a faulty theoretical framework in analyzing economic activity, they misunderstand how expectations enter into economic decision making, and they do not recognize the actual consequences of the monetary policy necessary to stabilize NGDP expectations.

Is there any truth to these claims?   What about our "faulty theoretical framework?"  He writes:

Most relevant and troublesome for evaluating NGDP targeting is that there is no such thing as aggregate demand that equates with aggregate supply at a single price level. 
In fact, the social economy is made up of a vast network of distinct markets that are integrated into a complex division of labor through the inter-temporal production structure and the use of a general medium of exchange. Productive activity, therefore, is the result of a vast number of decentralized decisions made by a multitude of different entrepreneurs at different places in the production structure.

Well, I certainly have no particular dispute with his broad description of the market economy.   I would add a bit more emphasis on creative destruction--innovation by entrepreneurs introducing new goods and services and new methods of producing existing goods and services.

So far, there is only one major difference.   In my view, there is something in a market economy that is usefully framed as "aggregate demand."   And further, it can equal "aggregate supply" at a single "price level." However, this framing of aggregate demand and supply is fully consistent with an understanding that a market order is a vast network of distinct markets.  (I might add, interrelated markets.)

He goes on to discuss capital:

Capital is not a blob of homogenous schmoo (Foss and Klein 2012, pp. 105-30), so investment is not a homogenous ‘I’ (Garrison 2001).

I certainly don't think of capital as "homogenous schmoo," and would even grant that investment is not a homogenous "I."    Of course, the nominal volume of spending on newly produced capital goods is an actual flow of money expenditure.  It is a sum of the amount spent on a variety of different things.

But then, literally identical drill press machines can be used for a variety of purposes--continuing to produce some variety of automobile that no one is going to want or else producing washing machines in an insufficient quantity to meet an unanticipated demand.

That doesn't make the role of the price of drill press machines in coordinating their supply and demand irrelevant.    Still, even if the price of drill press machines does coordinate the supply and demand for drill press machines, there is no guarantee that people will want to purchase all of the cars that some of the drill press machines were used to produce.   For example, some other entrepreneur may have innovated and introduced a new type of car that people like better.

Similarly, the heterogeneous nature of  capital goods doesn't mean that interest rates cannot coordinate saving and investment.   However, even if saving and investment are coordinated, there is no guarantee that the particular capital goods being produced will help produce the products that people are most willing to buy.  Because of creative destruction, it is likely that there will nearly always be "malinvestment."   Capital goods will be produced that in retrospect should not have been produced.  Instead, the resources would have been better used to produce something else.

Ritenour then states:

It is possible for people to decrease their demand for consumer and producer goods if they increase their demand to hold money. This would only lead to wastefully idle resources, however, if prices for these resources remained above market-clearing levels. This will not persist, of course, if prices are allowed to adjust (Hutt 1979, pp. 138-39).

Exactly, the first portion is exactly what aggregate demand is about.   It refers to a situation where the quantity of money or the demand to hold money shifts resulting in either a surplus of money or a shortage of money.

A surplus of money is matched by a shortage of goods and services, and that is what it means for aggregate demand to exceed aggregate supply.   A shortage of money is matched by a surplus of goods and services, and that it what it means for aggregate demand to be less than aggregate supply.   And finally, if the quantity of money is equal to the demand to hold money, there is no shortage or surplus of output.  Aggregate demand is equal to aggregate supply.

How does this relate to a "single" price level?    If the prices of both final goods and resources adjust, then the real quantity of money will adjust to match the demand, closing off any surplus or shortage of money.   The primary problem with Hutt's account is the assumption that the problem is necessarily the price of the resource in surplus and that it is the fault of obstinate labor unions preventing the adjustment.  

While unions certainly could cause problems, if output prices fail to fall in the face of an excess demand for money, no amount of wage cutting will help reduce unemployment.    The problem isn't with the relative price of some resource, the real wage in this instance, but rather with the price level and the real quantity of money.   Further, there have been many historical instances where unions are unimportant, weak, or even nonexistent, and reductions in spending on output have resulted in extensive reductions in both output and employment.

Market Monetarists (and nearly all mainstream economists these days,) recognize that decreases in prices and wages increase real money balances and expand aggregate demand and that this can bring the real volume of sales into balance with the productive capacity of the economy.

Something like this is behind what is called the "natural rate hypothesis."    In the long run, aggregate supply is vertical at the level of output  that depends on the ability and willingness to produce goods and services.   Aggregate demand solely influences the price level, including the prices of productive resources like labor.

Market Monetarists insist that expanding the nominal quantity of money is a much better way to raise the real quantity of money and bring it into balance with the real demand to hold money, simultaneously raising nominal and real aggregate demand so that it matches potential output.

By the way, Market Monetarists, like just about everyone else, recognizes that while an excess demand (shortage) of money is matched by an excess supply (surplus) of output, that output is heterogeneous.   Each and every type of output has its own supply and demand, and the difference between each supply and demand, evaluated at the current market price, must be summed to find the net excess demand or supply of output.

If aggregate demand equals potential output, then the sum of the excess demands for all types of output is zero.   This implies that there can very well be surpluses of some goods or services, but that these surpluses are matched by shortages of other types of goods and services.

 In other words, it is almost exactly like what a naive interpretation of Say's Law claims must be true at all times.  Supposedly, supply creates its own demand, and so while there may be a surplus, or glut, of some goods, this is because resources have been used to produce the wrong goods or services.   The markets for the goods that were not produced because of the misallocation of resources are in shortage.

That prices fall in markets with surpluses and rise in markets with shortages is exactly how market signals are created to shift resources to produce the most highly valued goods.   In my view, in a world of creative destruction, this is happening all the time.  The market order is a system of constant mutual adjustment to constant change.

Ritenour continues:

Instead of allowing markets to clear via price adjustments according to subjective preferences, market monetarists advocate that monetary authorities bring about market stability by increasing the money supply. Such inflation, however, will not necessarily equilibrate the specific demand for and supply of money on the part of the individuals who are experiencing the excess demand. If prices and wages are that sticky, there will need to be a significantly large increase in NGDP to maintain equilibrium.

Actually, Market Monetarists favor having monetary authorities adjust the quantity of money either up or down to keep it equal to the demand to hold money.  I find it odd that so many Austrians have this blind spot.   It is always a critique of "inflation" (an increase in the quantity of money,) rather than considering the opposite situation where a reduction in money demand leads to a surplus of money, a shortage of output, and so a higher price level to reduce the real quantity of money and lower real aggregate demand to match potential output.   Market Monetarists favor a reduction in the quantity of money in this situation.

The notion that an expansion in the quantity of money cannot accommodate an added demand to hold money because it fails  to reach the specific individuals who want to hold more money is absurd.    It ignores the fundamental proposition of monetary theory.

The individuals who want to hold more money actually do obtain it by spending less out of their current incomes or selling some asset they own.  Of course, those from whom they would have purchased the goods or those to whom they sold the assets now have less money.    As those people in turn restrict expenditures or sell assets, they rebuild their money holdings but the shortage shifts to still others.

The fundamental proposition of monetary theory is that the individual can adjust his or her actual money holdings to desired money holdings easily.   It is rather that if the total quantity of money is fixed, then the market as a whole must adjust its desired money holdings to the existing quantity.   For this adjustment to be consistent with economy-wide coordination, what must change is the price level, both of output and productive resources including labor.

If the quantity of money changes to match the increase in the demand to hold money, then those choosing to accumulate money holdings do so, but the effect is identical to what would have happened if they had chosen to purchase whatever is purchased with the newly- issued money.   For example, if people choose to reduce expenditures out of current income and accumulate funds in their checking accounts, and banks create new money and make loans to various businesses, then the effect is the same as if those accumulating the money had instead made those loans directly to those businesses.   Those accumulating money spend less on some goods, and the businesses spend more on other goods.   There is no change in nominal GDP.  

There is a reallocation of resources.  But there would have been a reallocation of resources anyway.   What an adjustment in the quantity of money allows is for this reallocation to occur  without everyone in the market having to adjust their money prices (including wages) to increase the real quantity of money to match the demand.  With an increase in the nominal quantity of money, those who need to expand production get a signal of increased nominal and real demand.   Those who need to contract get a signal of reduced nominal and real demand.

This is as opposed to everyone getting a signal of reduced nominal demand, which is nearly always taken as a signal of reduced real demand and so creates the mistaken response of all firms cutting production.   Only when the resulting surpluses of resources result in lower resource prices is the reality that all nominal opportunity costs have fallen (and real opportunity costs are the same) signalled to firms, so that they can expand both production and employment.  The reallocation occurs anyway, with the signal to shift the allocation of resources arriving as some firms see falling costs turn their losses into profits sooner than others.  

Anyway, since Market Monetarists favor a target growth path for NGDP,  the notion that "there will need to be a significantly large increase in NGDP to maintain equilibrium," is beside the point.   All that Market Monetarists propose is that increases in the demand for money be accommodated by increases in the nominal quantity of money so that they require no change in NGDP.   We are not proposing to raise NGDP so that...I don't know what.   No one ever adjusts their expenditure because they are short on money?    I am not sure that would be possible.  

As is so common, there is an implicit assumption that Market Monetarists are proposing to target real GDP or unemployment.   Or perhaps more realistically, old arguments against targeting real GDP or unemployment are being trotted out where they don't apply.   Market Monetarists are not proposing to increase nominal GDP whatever amount is necessary to close the output gap (raise real output to potential output) or lower the unemployment rate to the natural unemployment rate.

Retinour makes the following claim:

Additionally, decreases in demand are always experienced in particular markets. When there is either a decrease in demand or a decrease in supply in the face of elastic demand, total expenditures will drop. Note however, that spending is the effect of the changes in the preferences of buyers and sellers, not the cause of the decrease in demand or supply. Salerno (2006) shows how this applies to the broad social economy. Market-clearing prices (and quantities) are determined on every market by the interaction of individuals’ value scales on which goods are valued in relation to one another and to money. It is only after market equilibrium prices and quantities and, therefore, the value of money, have already been determined that “spending”occurs.

I am not sure how much of this is all due to Salerno or even if Ritenour correctly expresses Salerno's views.   (I haven't read Salerno 2006.)   But the way Ritenour describes it, Salerno is promoting an absurdly Walrasian account of the economy.   First the equilibrium prices are determined, then everyone makes exchanges.   I take a more "market process" view of the market economic order.  

On the other hand, I don't think people choose to spend a certain amount of money on some particular good independent of the price and quantity combination it represents.    From a micro perspective, the focus on spending comes from the budget constraint, keeping in mind that choosing to accumulate more money is a use of money income as well.

In later posts I will comment on Ritenour's criticisms of the Market Monetarist view of expectations and the actual consequences of changes in the money supply necessary to keep NGDP growing at a  slow steady rate.


  1. That last paragraph is a good catch, and I don't think Ritenour catches Salerno's position (although, I can't speak for Salerno). If spending can only occur at the market clearing price, I wonder how Ritenour thinks that people's value scales will become known. This was the entire premise behind Mises' socialist calculation argument: you need the bidding process for market prices to even form.

  2. "This would only lead to wastefully idle resources, however, if prices for these resources remained above market-clearing levels. This will not persist, of course, if prices are allowed to adjust (Hutt 1979, pp. 138-39)."

    If prices are allowed to adjust?

    They have been adjusting for 20 years in Japan, falling and falling, without positive result. How many decades do we have to endure for the "equilibrium" to be reached?

    Do any Austrians ponder what a 20-years-long recession does to investor sentiments, or the idea of building a career?

    (BTW, I always refer to the Austrian School as the Afro-Brazilian School or Monetary Policy. No real reason, I just know it will offend them.)

    The Austrians start from a flawed ideal, a demented afflatus that drives their reasoning, and that reasoning is that price stability and the gold standard are the ends of monetary policy, not even just the means (very flawed means, btw).

    The peevish fixation on price stability, or necessary deflation, permeates the Austrian and Afro-Brazilian monetary world.

    In the USA, we had great years from 1982 through 2008. That is along test, and inflation ranged between just under 2 percent to more than 5 percent. Moderate inflation.

    BTW, if you want price stability (however measured) then you should love a central bank. In Japan they have near perfect price stability since 1992, only very slight deflation (thought the cumulative effects are noticeable). And in the USA, we have had near-perfect price stability since 2008. Inflation near 1 percent.

    It just seems like price stability does not bring prosperity.

    Except for that, I love price stability.

  3. I agree with most everything in this post but I have a question on:

    "Market Monetarists, like just about everyone else, recognizes that while an excess demand (shortage) of money is matched by an excess supply (surplus) of output..."

    I can imagine a scenario where demand for money increases and in which wages are sticky. The increased demand for money leads to falling sales. Firms keep careful track of their inventories and quickly see them rising so they cut back on production and reduce employment.

    So does a shortage of money have to be matched by a surpluses in goods markets ? In the above scenario all goods markets stay in equilibrium, even as NGDP falls and cash balances increase. Even the labor market could be said to be in equilibrium since if they so desired firms and workers could negotiate lower wages to avoid lay-offs which would lead to lower prices and greater sales.

  4. BTW, for those of you concerned with price stability and central banks: You should be singing the Fed's praises.

    Since 2008, the PCE index has risen to about 177 from 110. Less than 7 percent up in five years.

    Ain't price stability grand?

  5. Benjamin, Austrians don't advocate price stability.

  6. BTW, those numbers should have been 117 and 110, a very small increase in the index over a five-year period.

    OT, but Woolsey talked about a commodities base index for monetary policy recently.

    I have devoted long thought to commodities prices, and now (drum roll) here is my conclusion.

    They are sending false signals, for a reason Scott Grannis alludes to: We get better continuously in our use of commodities. we use less, and the price of the commodity becomes less important, as in oil. (Gold is sui generis, the price set by retail buyers in India and China).

    So a commodity can rise in price, but that is neither a sign of economic strength, or inflation. It may be a sign we use use less of that commodity, and we are less price sensitive.

    My car gets 45 mpg rather than 12, so if gasoline costs double, I am still ahead.

    This, many argue, is in fact what happened to Fed policy in 2008. They saw commodity and oil prices rising, and get scared, and tightened monetary policy just as consumers and business leveraged to the hilt to buy real estate.

    That was a disaster.

    Going forward, anyone who uses commodities prices to set monetary policy will probably end up asphyxiating their economy.

    In brief, if you want to know what is happening to inflation, look at the CPI or PCE deflator, and even those indices may overstate the case.

    The Cleveland Fed has an index of inflationary expectations, that has been far, far, far more accurate in forecasting inflation than commodity prices.

    And gold? Gold collapsed just as the world's central banks went to heavy QE. Yeah, gold ranks up there with astrology.

    Jonathan Finegold: Well, what do Austrians want? I can never figure it out. Free banking? They talk as if they have the secret cure, and there is frequent mention of gold. With your last name, I assume you like the yellow metal....

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