All posts tagged Steven Horwitz

Spain’s quasi-depression – an Austrian ‘bust’ or a monetary contraction? Or both?

A couple of days ago I wrote a post on the behavior of prices in the ‘bust’ phase of an Austrian style business cycle. My argument was that the Austrian business cycle story basically is a supply side story and that in the bust there is a negative supply shock. As a consequence one should expect inflation to increase during the ‘bust’ phase.

My post was not really about what have happened during the Great Recession, but it is obvious that the discussion could be relevant for understanding the present crisis.

Overall I don’t think that the present crisis can be explained by an Austrian style business cycle theory, but I nonetheless think that we can learn something relevant from Austrian Business Cycle Theory (ABCT) that will deepen our understanding of the crisis.

Unlike Austrians Market Monetarists generally do not stress what happened prior to the crisis. I do, however, think that we prior to the crisis saw a significant misallocation of resources in some countries. I myself in the run up to the crisis – back in 2006/7 – pointed to the risk of boom-bust in for example Iceland and Baltic States. Furthermore, in hindsight one could certainly also argue that we saw a similar misallocation in some Southern European countries. This misallocation in my view was caused by a combination of overly easy monetary conditions and significant moral hazard problems.

This discussion has inspired me to have a look Spain in the light of my discussion of ABCT.

My starting point is to decompose Spanish inflation into a supply and a demand component. I have used the crude method - the Quasi-Real Price Index – that I inspired by David Eagle developed in a number of posts back in 2011. I will not go into details with the method here, but you can read more here.

This is my decomposition of Spanish inflation.

Spain inflation QRPI

The story prior to the crisis is pretty clear. Both demand and supply inflation is fairly stable and there are no real sign of strongly accelerating demand inflation. However, the picture that emerges in the “bust-years” is very different.

As the graph shows supply inflation spiked as the crisis played out and has remained elevated ever since and we are now seeing supply inflation around 5%. However, at the same time demand inflation has collapsed and we basically have had demand deflation since the outbreak of the crisis.

I would stress that my crude method of decomposing inflation assumes that the aggregate supply curve is vertical. That obviously is not the case and that likely lead to an overestimation of the supply side inflation. That said, I feel pretty confident that the overall story is correct.

Hence, the Spanish story in my view provides some support for an Austrian-inspired interpretation of the crisis in the Spanish economy. As the crisis in Spain started to unfold the Spanish economy was hit by a large negative supply shock, which caused supply inflation to spike. There is clearly an Austrian style argument to be made here. Investors realised that they had  made a mistake and therefore economic resources had to reallocated from unprofitable sectors (for example the construction sector) to other sector. With price and wage rigidities this is a supply shock.

A negative supply shock will not in itself cause a depression 

However, this is not the whole story. A purely Austrian interpretation of the crisis misses the main problem in the Spanish economy today – the collapse in aggregate demand. Despite the sharp increase in Spanish supply inflation headline inflation (measured with the GDP deflator) has collapsed! That can only happen if demand inflation drops more than supply inflation increases. This is exactly what have happened in Spain. In fact we have a situation where we have high suppply inflation AND demand deflation.

What have happened is that the Spanish economy has moved from the ‘bust’ phase to what Hayek called ‘secondary deflation’. The ‘secondary deflation’ is the post-bust phase where a negative demand shock causes the economy to go into depression and a general deflationary state. This is a massively negative monetary shock and this is the real cause of the prolonged crisis.

The ‘secondary deflation’ is not a natural consequence of an Austrian style boom-bust, but rather a consequence of a monetary contraction. In that sense the secondary deflation is more monetarist in nature than Austrian.

In the case of Spain the monetary contraction is a direct consequence of Spain’s euro membership. If a country has a freely floating exchange rate then a negative supply shock – the bust – will cause the country’s currency to depreciate. However, due to Spain’s membership this obviously is not possible. The lack of depreciation of Spain’s currency de facto is monetary tightening (process that plays out is basically David Hume’s Price-Specie-flow story).

In fact the monetary tightening in Spain has been massive and has caused demand inflation to drop from around 4% to today more than 5% (demand) deflation!

This obviously is the real cause of the continued crisis in the Spanish economy. So while my decomposition of Spanish inflation seems to indicate that there has been an ‘Austrian story’ in the sense that there Spain has gone through of re-allocation (the negative supply shock) the dominant story is the collapse in aggregate demand caused by a monetary contraction.

The counterfactual story – and why a Austrian style bust is not recessionary

The discussion above in my view illustrates a clear problem with the Austrian story of the business cycle. I my view Austrians often fail to explain why a reallocation of economic resources will have to lead to a recession. Yes, it is clear that we will get a temporary downturn in real GDP in the bust phase, but there is nothing in ABCT that explains that that will turn into a depression-like situation as is the case in Spain.

What would for example have happened if Spain had had its own currency and an independent monetary policy regime where the central bank had targeted nominal GDP – for example along a 6% NGDP growth path.

Lets say that the entire initial Spanish downturn had been cause by a bubble bursting (it was not), but also that the central bank had been targeting a 6% NGDP growth path. Hence, as the bubble bursts real GDP growth decelerates sharply. However, as the central bank is keeping NGDP growth at 6% inflation will – temporary – increase. Most of the rise in inflation will be caused by an increase in supply inflation (but demand inflation will not drop). This is temporary and inflation will drop back once the re-allocation process has come to an end. Hence, there will not be a deflationary shock.

Therefore, the drop in real GDP growth is a necessary adjustment to a bubble bursting. However, the drop will likely be rather short-lived as aggregate demand (NGDP) is kept “on track” due to the NGDP target and hence “facilitate” a smooth re-allocation of resources in the Spanish economy.

This in my view clearly illustrates why we cannot use Austrian Business Cycle Theory to explain why the crisis in the Spanish economy is as deep as it is. Clever Austrians like Roger Garrison and Steve Horwitz will of course agree that ABCT is not a theory of depression. You need a monetary contraction to create a depression. This is Steve Horwitz on ABCT:

Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust.  It isn’t.  As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom.  It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust.  Again, it’s a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it.  The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment.  But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events.  We know it has to happen, but the where and when are unique, not typical, features of business cycles.

… The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

…The ABCT cannot explain the entirety of the Great Depression.  It simply can’t.  And adherents of theory who make the claim that it can are not doing the theory any favors.  What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929.  It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.  Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn’t tell us much.  Once the turning point is reached, there’s not a lot that ABCT can say other than to let the healing process unfold unimpeded.

I think Steve’s description of ABCT is completely correct and in the same way as Steve doesn’t believe that ABCT can explain the entire Great Depression I would argue that ABCT cannot explain the Spanish crisis – or the euro crisis for that matter. Yes, there undoubtedly is some truth to the fact that overly easy monetary policy from the ECB contributed  to creating a unsustainable boom in the Spanish economy (and other European economies). However, ABCT cannot explain why we still five years into the crisis are trapped in a deflationary crisis in the Spanish economy. The depressionary state of the Spanish economy – at this stage – is nearly fully a consequence of a sharp monetary contraction. The bust has clearly long ago run its natural cause and what is keeping the Spanish economy from recovering is not a necessary re-allocation of economic resources, but very tight monetary conditions in Spain.

Conclusion: ABCT provide important insights, but will not help us now 

So to me the conclusion is pretty clear – Austrian Business Cycle theory do indeed provide some interesting and important insights to the boom-bust process. However, ABCT only explains a very limited part of the crisis in the Spanish economy and the euro zone for that matter. Had monetary policy been kept on track as the re-allocation process started the adjustment process in the Spanish economy would likely have been fairly painless and swift.

Unfortunately that has not been the case and monetary policy has caused the Spanish economy to enter a ‘secondary deflation’ and clever Austrians know that that is not a result of a bust, but rather a result of a monetary disequilibrium resulting from a excessive demand for money relative to the supply of money. There is no reason to worry about about reflating a bubble. The bubble has been deflated long ago.

PS The purpose of this post has been to discuss ABCT in the light of the crisis in Spain. However, the purpose has not been to tell the full story of Spain’s economic problems. Hence, it is clear that Spain struggles with serious structural problems such as extremely damaging firing-and-hiring rules. This structural problem significantly contribute to deepen and prolong the crisis, but it has not been the cause of the crisis.

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by Lars Christensen on April 9, 2013  •  Permalink
Posted in ABCT, Austrian economics, David Eagle, Hayek, Roger Garrison, Spain
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Posted by Lars Christensen on April 9, 2013

http://marketmonetarist.com/2013/04/09/spains-quasi-depression-an-austrian-bust-or-a-monetary-contraction-or-both/

The Austrian bust: HIGHER inflation and relative deflation

I have been thinking about an issue that puzzles me – it is about inflation in an Austrian School style bust.

Here is the story. If we think about a stylized Austrian school boom-bust then the story more or less is that easy money leads to an unsustainable boom that eventually – for some reason – will lead to a bust.

What people often fail to realize is that the Austrian business cycle theory basically is a supply side story.

Austrians will hate it, but you can tell much of the story within an AS/AD framework. The graph below is an illustration of this.

AS AD - AS shift rightwards

What happens is that the central bank cuts interest rates below the Wicksellian natural interest rate. Investors are tricked into thinking that it is the natural interest rates that has fallen and as a result investments are increased. Austrians will of course object by saying “it is not a overinvestment theory, but a malinvestment theory”. Yes, that is right, but that is not relevant for the question I want to look at here.

The boom happens not because of higher demand, but because of over (and mal) investment. The production capacity of the economy is hence expanded – the AS curve shifts to the right during the Austrian boom and production increases from Y1 to Y2. We ignore the demand effects – so we keep the AD unchanged – as the Austrians really are not paying much attention to this part of the story anyway (and yes, I am aware the there is relative demand story – private consumption vs investments).

Notice what happens with the price level initially. Prices drop from P1 to P2. Obviously that would not necessarily have to be the case if the AD curve also have shifted to the right as well (but that is not important for the story here). However, this pretty well illustrates the Austrian story that “headline” inflation will not necessarily increase during the boom. What happens – and we can obviously not realize that by just looking at AD and AS curves – is that we get what Austrians call relative inflation. Some prices rise, but the aggregate price level does not necessarily increase.

So far so good. I know Austrian economists would say that I told the story in the “wrong way”, but I guess they will agree on the main points – Austrian Business Cycle Theory is mostly about the supply side of the economy and that the aggregate price level will not necessarily have to increase during the boom phase.

Now we turn to the bust phase…

At some point investors realise that they have made a mistake – the natural interest rate has not really dropped. Therefore, what they thought were good and profitable investments are not really that great. So as a result investors cut back investments – after the “bubble” have bursted a large part of the production capacity in the economy is worthless. This is a negative supply shock! The AS shift back leftwards.

AS AD - AS shift leftwards

What is the result of this? Well, it is simple – the price level increases from P2 to P1. We get higher inflation. This might seem counterintuitive to most people – that the bust leads to higher rather lower inflation – but remember this is due fact that the Austrian boom-bust cycle primarily is a supply side story.

‘Benign’ inflation should be welcomed

And this brings me to what I really wanted to say. An increase inflation should be welcomed if it reflects a rational and undistorted reaction to investors realising that they have made a mistake. That is exactly what happens in an Austrian style bust. We might get relative deflation/disinflation, but the aggregate price level increases due to the negative supply shock.

Therefore, when Austrians often argue that the bust should be allowed to play out without any interference from the government or the central bank then that logically mean that they should welcome an increase in inflation in the bust phase of the business cycle. That obvious is not that same saying that monetary policy should be eased in the bust phase, but inflation should nonetheless be allowed to increase as we get “benign” inflation.

However, in my view that would mean that it would be wrong from an Austrian perspective for the central bank to tighten monetary policy in response to rise in (supply) inflation during the bust. Those Austrian economists who favour NGDP level targeting – like Anthony Evans and Steve Horwitz – would likely agree, but what about the “internet Austrian”? And what about Bob Murphy or Joe Salerno?

Obviously the story I have told above is a caricature of the Austrian Business Cycle theory, but I think there is a relevant discussion here that need to be addressed. Is the aggregate price level likely to rise in the bust phase as natural consequence of market forces being allowed to run it cause?

The reason that I think this debate is important is that some Austrians spend a lot of time arguing that the deflationary tendencies that we see for example in Europe at the moment are a natural and necessary bursting and deflating of a bubble. However, IF we indeed were in the bust phase of a Austrian style business cycle then we would not be seeing deflationary tendencies. We would in fact be seeing the opposite – we would see HIGHER inflation, but at the same time relative deflation.

Obviously this is not what we are seeing in the US and Europe today - inflation in both the US and the euro zone is well-below what it was during the “boom years”. That mean that we are not in the bust phase of an Austrian style boom-bust. There might very well have been a boom-bust initially (I believe that was the case in some European countries for example), but we have long ago moved to another phase – and that is what Hayek termed secondary deflation – a downturn in the economy caused by an monetary contraction.

PS Take a look at what happened in the US in 2007-8. Overall inflation did in fact increase as the economy was slowing, while we at the same time had relative deflation in the form of falling property prices. However, starting in the Autumn of 2008 we clearly saw across the board deflationary tendencies – here it is pretty clear that we entered a secondary deflationary phase caused by a monetary contraction. This is consistent with an Austrian interpretation of the Great Recession, but it is not a story I have heard many (any??) Austrians tell. And of course it is not necessarily the story I would tell – even though I think there is a lot of truth in it.

PPS The graphs above could indicate that both production and prices shifts back to the initial starting point during the bust. That obviously would not have to be the case as I here have ignored the shift in the AD curve and as any Austrian would note the AS/AD framework is not telling us anything about relative prices.

24 Comments
by Lars Christensen on April 7, 2013  •  Permalink
Posted in ABCT, Anthony Evans, Austrian economics, Bob Murphy, Steven Horwitz
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Posted by Lars Christensen on April 7, 2013

http://marketmonetarist.com/2013/04/07/the-austrian-bust-higher-inflation-and-relative-deflation/

Steve Horwitz’s “Introduction to US Monetary Policy”

Steve Horwitz is out with an new paper – “An Introduction to US Monetary Policy”. I haven’t read the paper yet, but I am sure it is very good. Steve always writes interesting and insightful stuff about monetary policy issues. I hope to find time to read it in the coming days, but until I have more to say about that paper you should have a look. Here is the abstract:

This study examines the history and operation of the Federal Reserve System (“the Fed”). It explores the Fed’s origins in American economic history and emphasizes the political compromises that produced it. It seeks to provide an accessible explanation of how the Fed attempts to change the money supply and of the structural challenges it faces as it attempts to get the money supply correct. The paper uses the framework thereby developed to examine recent monetary policy, including quantitative easing. Inflation and deflation result when the Fed creates too much or too little money, and the study discusses the causes and costs of both in detail. The paper concludes with an examination of alternatives to central banking, including the gold standard and a system of competition in money production known as free banking

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by Lars Christensen on April 4, 2013  •  Permalink
Posted in Steven Horwitz
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Posted by Lars Christensen on April 4, 2013

http://marketmonetarist.com/2013/04/04/steve-horwitzs-introduction-to-us-monetary-policy/

The last brick – RIP James M. Buchanan

Nobel Prize winning economist and founding father of the Public Choice school James M. Buchanan has died at age 93. His friends and students have already offered many kind words in his memory. Here I quote two of my friends professors Steve Horwtiz and Peter Kurrild-Klitgaard.

Here is Pete:

James M. Buchanan, RIP. If making a difference is what matters, he was one of the five most influential thinkers of the last 50 years. Sharp as a knife into his 90s and always the scholar.

And Steve:

There is much that one can say about him (Buchanan), not the least of which is that he was still intellectually sharp and active into his 90s. In short: he changed the face of economics and politics and advanced the cause of liberty as much as anyone in the second half of the 20th century…

…No one who wishes to talk responsibly about politics can be ignorant of public choice theory. No one should ever invoke the language of market failure (including externalities) without having digested his work on government failure. And people who run around talking about the constitution better be able to understand something of constitutional political economy.

Beyond all of that, he was a role model of the old school scholar: widely read and properly skeptical of turning economics into an engineering discipline. He was, at bottom, a humanist and a liberal in the oldest and best senses of the terms. And best of all: he was utterly unimpressed by degrees from fancy schools.

Buchanan produced an enormous amount of scholarly works including numerous books in his long life. Best known is probably The Calculus of Consent which he co-authored with Gordon Tullock. However, the works that had the biggest influence on my own thinking undoubtedly was “What should economists do?” and “Cost and Choice”.

Even though Buchanan primarily was a constitutional economist and a Public Choice theorist he also contributed to monetary thinking. His so-called brick standard was particularly intriguing. Here is Pete Boettke and Daniel Smith on Buchanan and the brick standard:

James Buchanan, sought to bring his extensive work on rule-making to bear in envisioning a monetary regime that could operate within a contemporary democratic setting. From the start, Buchanan (1999[1962]) eschewed the ‘presuppositions of Harvey road’ that held that economic policy would be crafted and implemented by a group of benevolent and enlightened elites. Buchanan set out to make the case for a monetary regime using comparative institutional analysis that compared monetary regimes in real, not ideal settings.

Buchanan (1999[1962]) believed that it was not so much the specific type of monetary regime adopted, but the set of rules that defined that regime. Buchanan argued that the brick standard, a labor standard, or a manager confined by well-defined rules, would all put a stop to the government growth let loose by the fiscal profligacy encouraged by the wide scale acceptance of Keynesian ideas in the political realm (see Buchanan and Wagner (2000[1977]). The brick standard, as defined by Buchanan, would be a monetary regime that allowed anyone to go to the mint with a standard building brick of a specified quality and exchange it for the monetary unit, and vice versa. As the general price level fluctuated, market forces would cause automatic adjustments as people would exchange money for bricks when the price level rose above the equilibrium level, and bricks for money when the price level fell below the equilibrium level. Under this regime, market actors, guided by profits and losses would be the mechanism that achieved price predictability, not a government-entity entrusted with the goal of achieving it. In addition, a brick standard would, most likely, divorce domestic monetary policy from international balance of payment and exchange rate policies due to the fact that a brick standard would be unsuitable for those purposes.

For Buchanan (1999[1962], 417), it came down to a toss-up between a brick type standard and a limited manager. What mattered most for monetary predictability was that the rules that set up the monetary regime must be of the ‘constitutional’ variety. In other words, the rules must be set to be ‘relatively absolute absolutes’ in order to protect them from tampering.

R.I.P. James M. Buchanan

—-

Update – other economists and scholars on James Buchanan:

Steve Horwitz

Daniel Kuehn

Eamonn Butler

Don Boudreaux (also from Don in 2005 and Don in WSJ)

Mark D. White

Grover Cleveland

Mario Rizzo

David Boaz

Robert Higgs

David Henderson

Alex Tabarrok

Randall Holcombe

Peter Boettke

Ryan Young

Bill Woolsey

Veronique de Rugy

Nick Gillespie

Arnold Kling

Brad DeLong

Christian Bjørnskov (in Danish)

Tyler Cowen (more from Tyler Cowen)

Lenore Ealy

Garett Jones

Charles Rowley

Edward Lopez

The Economist: Free Exchange

Buchanan

5 Comments
by Lars Christensen on January 9, 2013  •  Permalink
Posted in Daniel Smith, James Buchanan, Peter Boettke, Peter Kurrild-Klitgaard, Steven Horwitz
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Posted by Lars Christensen on January 9, 2013

http://marketmonetarist.com/2013/01/09/the-last-brick-rip-james-m-buchanan/

Guest post: Misunderstanding Say’s Law of Markets (Garrett Watson)

I have always wanted to promote the work of young scholars on this blog and have been grateful that a couple of gifted young economists have published guest posts on this blog. I want to continue that “tradition” and I am therefore happy that Garrett Watson – a student of Steve Horwitz at St. Lawrence University – has accepted my invitation to write a guest post for my blog.

Enjoy Garrett’s excellent discussion about the “Misunderstanding Say’s Law of Markets”. The post has previously been published on Tu Ne Cede Malis.

Understanding Say’s Law and the connection to monetary policy is key to understanding the present crisis. So enjoy Garrett’s guest post.

Lars Christensen

 

Guest post: Misunderstanding Say’s Law of Markets

- By Garrett Watson, St. Lawrence University

Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.

Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded – this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84).  This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40).  Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only – money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). Whilerelative over and under-production can occur, there is no limit to economic growth (41).

While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7).  Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

References

Anderson, William. “Say’s Law: Were (Are) the Critics Right?” Mises Institute1 (2001): 1-27. Mises Institute. Web. 19 Oct. 2012.

Blaug, Mark. “Say’s Law and Classical Monetary Theory.” Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. 143-160. Print.

Horwitz, Steven. “Say’s Law of Markets: An Austrian Appreciation,” In Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Steven Kates, ed. Northampton, MA: Edward Elgar, 2003. 82-98. Print.

Sowell, Thomas. On Classical Economics. New Haven [Conn.]: Yale University Press, 2006. Print.

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by Lars Christensen on November 1, 2012  •  Permalink
Posted in Guest blog, Guest post, Say's Law, Steven Horwitz
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Posted by Lars Christensen on November 1, 2012

http://marketmonetarist.com/2012/11/01/guest-post-misunderstanding-says-law-of-markets-garrett-watson/

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

9 Comments
by Lars Christensen on October 6, 2012  •  Permalink
Posted in Bubbles, David Beckworth, George Selgin, Larry White, NGDP Targeting, Nominal Income Targeting, Scott Sumner, Steven Horwitz, The Great Moderation, The Great Recession
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Posted by Lars Christensen on October 6, 2012

http://marketmonetarist.com/2012/10/06/the-counterfactual-us-inflation-history-the-case-of-ngdp-targeting/

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Cato-Unbound.org. Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

2 Comments
by Lars Christensen on September 11, 2012  •  Permalink
Posted in Austrian economics, Bryan Caplan, George Selgin, Reading recommendations, Steven Horwitz
Tagged , , ,

Posted by Lars Christensen on September 11, 2012

http://marketmonetarist.com/2012/09/11/steve-george-and-bryan-debate-austrian-economics-and-empirics/

Lorenzo and Horwitz debate Austrian economics

Back in April our friend Lorenzo did a interesting post on Austrian theory. That has now triggered a response from Steve Horwitz who defends the Austrian position. It is excellent stuff. It is a debate between two clever debaters and I have very strong sympathies for both gentlemen. However, I don’t have time today to go through the entire debate, but I will strongly recommend to my readers to take a look at this very interesting debate.

See here:

Lorenzo: About Austrian Economics

Steve’s response: Thoughts on Lorenzo on Austrian Economics

Lorenzo’s feedback to Steve: Response to Dr. Horwitz’s thoughts

Again, this is excellent stuff. Read it! We can all become more clever by debates like this. Thanks guys.

1 Comment
by Lars Christensen on June 27, 2012  •  Permalink
Posted in Austrian economics, Steven Horwitz
Tagged ,

Posted by Lars Christensen on June 27, 2012

http://marketmonetarist.com/2012/06/27/lorenzo-and-horwitz-debate-austrian-economics/

Lets concentrate on the policy framework

Here is Scott Sumner:

I’ve noticed that when I discuss economic policy with other free market types, it’s easier to get agreement on broad policy rules than day-to-day discretionary decisions.

I have noticed the same thing – or rather I find that when pro-market economists are presented with Market Monetarist ideas based on the fact that we want to limit the discretionary powers of central banks then it is much easier to sell our views than when we just argue for monetary “stimulus”. I don’t want central bank to ease monetary policy. I don’t want central banks to tighten monetary policy. I simply want to central banks to stop distorting relative prices. I believe the best way to ensure that is with futures based NGDP targeting as this is the closest we get to the outcome that would prevail under a truly free monetary system with competitive issuance of money.

I have often argued that NGDP level targeting is not about monetary stimulus (See here, here and here) and argued that NGDP level targeting is the truly free market alternative (see here).

This in my view is the uniting view for free market oriented economists. We can disagree about whether monetary policy was too loose in the US and Europe prior to 2008 or whether it became too tight in 2008/9. My personal view is that both US and European monetary policy likely was (a bit!) too loose prior to 2008, but then turned extremely tight in 2008/09. The Great Depression was not caused by too easy monetary policy, but too tight monetary policy. However, in terms of policy recommendations is that really important? Yes it is important in the sense of what we think that the Fed or the ECB should do right now in the absence of a clear framework of NGDP targeting (or any other clear nominal target). However, the really important thing is not whether the Fed or the ECB will ease a little bit more or a little less in the coming month or quarter, but how we ensure the right institutional framework to avoid a future repeat of the catastrophic policy response in 2008/9 (and 2011!). In fact I would be more than happy if we could convince the ECB and the Fed to implement NGDP level target at the present levels of NGDP in Europe and the US – that would mean a lot more to me than a little bit more easing from the major central banks of the world (even though I continue to think that would be highly desirable as well).

What can Scott Sumner, George Selgin, Pete Boettke, Steve Horwitz, Bob Murphy and John Taylor all agree about? They want to limit the discretionary powers of central banks. Some of them would like to get rid of central banks all together, but as long as that option is not on the table they they all want to tie the hands of central bankers as much as possible. Scott, Steve and George all would agree that a form of nominal income targeting would be the best rule. Taylor might be convinced about that I think if it was completely rule based (at least if he listens to Evan Koeing). Bob of course want something completely else, but I think that even he would agree that a futures based NGDP targeting regime would be preferable to the present discretionary policies.

So maybe it is about time that we take this step by step and instead of screaming for monetary stimulus in the US and Europe start build alliances with those economists who really should endorse Market Monetarist ideas in the first place.

Here are the steps – or rather the questions Market Monetarists should ask other free market types (as Scott calls them…):

1) Do you agree that in the absence of Free Banking that monetary policy should be rule based rather than based on discretion?

2) Do you agree that markets send useful and appropriate signals for the conduct of monetary policy?

3) Do you agree that the market should be used to do forecasting for central banks and to markets should be used to implement policies rather than to leave it to technocrats? For example through the use of prediction markets and futures markets. (See my comments on prediction markets and market based monetary policy here and here).

4) Do you agree that there is good and bad inflation and good and bad deflation?

5) Do you agree that central banks should not respond to non-monetary shocks to the price level?

6) Do you agree that monetary policy can not solve all problems? (This Market Monetarists do not think so – see here)

7) Do you agree that the appropriate target for a central bank should be to the NGDP level?

I am pretty sure that most free market oriented monetary economists would answer “yes” to most of these questions. I would of course answer “yes” to them all.

So I suggest to my fellow Market Monetarists that these are the questions we should ask other free market economists instead of telling them that they are wrong about being against QE3 from the Fed. In fact would it really be strategically correct to argue for QE3 in the US right now? I am not sure. I would rather argue for strict NGDP level targeting and then I am pretty sure that the Chuck Norris effect and the market would do most of the lifting. We should basically stop arguing in favour of or against any discretionary policies.

PS I remain totally convinced that when economists in future discuss the causes of the Great Recession then the consensus among monetary historians will be that the Hetzelian-Sumnerian explanation of the crisis was correct. Bob Hetzel and Scott Sumner are the Hawtreys and Cassels of the day.

11 Comments
by Lars Christensen on April 2, 2012  •  Permalink
Posted in Bob Murphy, Chuck Norris, Chuck Norris Effect, Evan Koeing, Free Banking, George Selgin, MM Research agenda, Monetary institutions, NGDP Targeting, Nominal Income Targeting, Peter Boettke, Robert Hetzel, Scott Sumner, Selgin's Monetary Credo, Steven Horwitz, The Great Recession
Tagged , , , , , , , , ,

Posted by Lars Christensen on April 2, 2012

http://marketmonetarist.com/2012/04/02/lets-concentrate-on-the-policy-framework/

Most people do “national accounting economics” – including most Austrians

Yesterday, I did a presentation about  monetary explanations for the Great Depression (See my paper here) at a conference hosted by the Danish Libertas Society. The theme of the conference was Austrian economics so we got of to an interesting start when I started my presentation with a bashing of Austrian business cycle theory – particularly the Rothbardian version (you know that has given me a headache recently).

The debate at the conference reminded me that most people – economists and non-economists – have a rather simple keynesian model in their heads or rather a simple national account model in their head.

We all the know the basic national account identity:

(1) Y=C+I+G+X-M

It is notable that most people are not clear about whether Y is nominal or real GDP. In the standard keynesian textbook model it is of course not important as prices (P) are assumed to be fixed and equal to one.

The fact that most people see the macroeconomics in this rather standard keynesian formulation means that they fail to understand the nominal character of recessions and hence nearly by construction they are unable to comprehend that the present crisis is a result of monetary policy mistake.

Whether austrian, keynesian or lay-person the assumption is that something happened on the righthand side of (1) and that caused Y to drop. The Austrians claim that we had an unsustainable boom in investments (I) caused by too low interest rates and that that boom ended in a unavoidable drop I. The keynesians (of the more traditional style) on the other hand claim that private consumption (C) and investments (I) is driven by animal spirits –  both in the boom and the bust.

What both keynesians and austrians completely fail to realise is the importance of money. The starting point of macroeconomic analysis should not be (1), but rather the equation of exchange:

(2) MV=PY

I have earlier argued that when we teach economics we should start out we money-free and friction-free micro economy. Then we should add money, move to aggregated prices and quantities and price rigidities. That is what we call macroeconomics.

If we can make people understand that the starting point of macroeconomic analysis should be (2) and not (1) then we can also convince them that the present recession (as all other recessions) is caused by a monetary contraction rather than drop in C or I. The drop in C and I are consequences rather the reasons for the recessions.

In this regard it is also important to note that Austrian Business Cycle Theory as formulated by Hayek or Rothbard basically is keynesian in nature in the sense that it is not really monetary theory. The starting point is that interest rates impact the capital structure and investments and that impacts Y – first as a boom and then as a bust. This is also why it is hard to convince Austrians that the present crisis is caused by tight money. (You could also choose to see Austrian business cycle theory as a growth theory that explain secular swings in real GDP, but that is not a business cycle theory).

Austrians and keynesians disagree on the policy response to the crisis. The Austrians want “liquidation” and the keynesians want to use fiscal policy (G) to fill the hole left empty by the drop in C and I in (1). This might actually also explain why “Austrians” often resort to quasi-moralist arguments against monetary or fiscal easing. In the Austrian model it would actually “work” if fiscal or monetary policy was eased, but that is politically unacceptable so you need to come up with some other objection. Ok, that is maybe not fair, but that is at least the feeling you get when you listen to populist part of the “Austrian movement” which is popular especially among commentators and young libertarians around the world – the Ron Paul crowd so to speak.

If people understood that our starting point should be (2) rather than (1) then people would also get a much better understanding of the monetary transmission mechanism. It is not about changes in interest rates to change C or I or changes in the exchange rate to change net exports (X-M). (Note of course in (1) M means imports and in (2) M means money). If we focus on (2) rather than (1) we will understand that a devaluation impact nominal demand by changes in M or V – it is really not about “competitiveness” – its about money.

So what we really want is a textbook that starts out with Arrow–Debreu in microeconomics and then move on (2) and macroeconomics. Imagine if economics students were not introduce to the mostly irrelevant national account identity (1) before they had a good understand on the equation of exchange (2)? Then I am pretty sure that we would not have these endless discussions about fiscal policy and most economists would then readily acknowledge that recessions are always and everywhere a monetary phenomenon.

————

PS I am of course aware this partly is a caricature of both the Austrian and the keynesian position. New Keynesians are more clever than just relying on (1), but nonetheless fails really to grasp the importance of money. And then some modern day Austrians like Steve Horwitz fully appreciate that we should start out with (2) rather than (1). However, I am not really sure that I would consider Steve’s macro model to be a Austrian model. There is a lot more Leland Yeager and Clark Warburton in Steve’s model than there is Rothbard or Hayek. That by the way is no critique, but rather why I generally like Steve’s take on the world.

PPS Take a Scott Sumner’s discussion of Bank of England’s inflation. You will see Scott is struggling with the BoE’s research departments lack of understanding nominal vs real. Basically at the BoE they also start out with (1) rather than (2) and that is a central bank! No surprise they get monetary policy wrong…

19 Comments
by Lars Christensen on February 26, 2012  •  Permalink
Posted in Austrian economics, Exchange rates, MV=PY, Ron Paul, Scott Sumner, Steven Horwitz, The Great Depression, The Great Recession, Transmission mechanism
Tagged , , , , ,

Posted by Lars Christensen on February 26, 2012

http://marketmonetarist.com/2012/02/26/most-people-do-national-accounting-economics-including-most-austrians/

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