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Guest blog: An Austrian Perspective on Market Monetarism

Alex Salter
asalter2@gmu.edu

Due to my insistence on the relevance of Austrian economics to monetary theory, and to Market Monetarism in particular, in the comments section of this blog, Lars has invited me to do a guest post on how Austrian conceptions of the market economy and the role of money lead to conclusions shared by many Market Monetarists.

As a disclaimer, I should note that scholars who identify as Austrian or Austrian-influenced hold an incredibly diverse set of beliefs, at least as diverse as adherents of other schools such as New Keynesianism, and the degree to which these scholars endorse what I write below varies widely. That being said, this is my best attempt to characterize what I believe are the uniquely Austrian contributions to economics and how they relate to Market Monetarism. I can think of no better way to do this than by relating these contributions to the two key tenets of Market Monetarism: markets matter and money matters.

All That…
Markets Matter
The coordinating role of markets is appreciated by many scholars of many schools of economic thought. What makes the Austrian conception unique is its particular focus on the market not as a Walrasian allocator or some other trading institution, but as a process. Whereas other schools focus on analyzing conditions of market equilibrium, the Austrian conception of the market process is a theory of disequilibrium. (Most Austrians believe there is an overall trend towards equilibrium due to entrepreneurial individuals constantly reallocating resources such that their value to society in finished goods and services asymptotically approaches their opportunity cost.)

The analysis centers on individuals pursuing given ends using specific means within the constraints imposed by imperfect knowledge and institutional context. Emphasizing purposeful action amidst a constellation of disequilibrium prices focuses the analysis on how the self-interested interactions of many, many agents brings about an extended order which reconciles each individual’s plans with those of everyone else, even when those plans are initially contradictory.

The massive web of trade relationships coordinated by a functioning price mechanism which economizes on the knowledge any one actor needs is central to market process economics. Fundamental to this idea is the concept of economic calculation –the process by which profit-driven individuals rationally allocate resources to their highest-valued uses through the ex ante expectation of profit and the ex post realization of profit. Economic calculation, with the profit and loss system as the feedback mechanism, is the way which individuals integrate themselves within the extended order to satisfy their own wants while simultaneously transmitting information back to the system. In order for economic calculation to be possible, society must have achieved a division of labor extensive enough for the adoption of a widely-used medium of exchange –in a word, money.

Without money as a common denominator, economic calculation could not extend beyond the provision of final consumption goods and the simplest capital goods. Technological progress, and hence economic growth, would progress at a snail’s pace if it progressed at all. The extensive capital structure of an economy could not exist without the medium of money. Thus we have a clear segue to the second of Market Monetarism’s core tenets: money matters

Money Matters
Since all goods are priced in terms of money, money is the cornerstone of economic calculation. When the money market is in equilibrium (when the supply of money equals the demand to hold it) the purchasing power of money is stable and the prices of various goods and services reflect real (as opposed to nominal) factors. However, the money market is not always in equilibrium. The supply of money can exceed the demand to hold it and vice versa. This is the root of many Austrians’ rejection of the (short-run) neutrality of money. Consider an excess supply of money brought about by a central bank unnecessarily engaging in open market operations.

This intervention gives an advantage to the first recipient of the new money relative to all other market actors, and the first recipient’s spending on his or her preferred consumption bundle creates a (admittedly very small) distortion in relative prices. As the new money spreads throughout the economy, these relative price discrepancies grow; since prices are the chief signals to which market actors respond, these price discrepancies lead to a misallocation of resources. (This phenomenon is known as the Cantillon effect, named after the Irish economist who first wrote about it in the early 18th century.) Thus an irresponsible central bank can be a source of significant economic disturbance.

What we want is a monetary framework which is stable enough to facilitate rational economic calculation while still allowing prices to reflect real factors. This is why many Austrians view Market Monetarism favorably: Given the existence of a central bank, pursuing a policy of nominal income targeting stabilizes the money market by supplying market actors with money when their demand to hold money exceeds its supply, and soaking up excess money when the supply of money exceeds the demand to hold it. This can be achieved either through a static or dynamic nominal income target. To see how, consider Marshall’s conception of the money market, where the purchasing power of money –its “price” –is determined by the supply and demand of money:

(1) Ms=M*
(2) Md=φPy

These two equations say the supply of money (Ms) is exogenously set at M* (as under a central bank), and the demand to hold money (Md) is proportional to nominal income. φ is called fluidity, which can be thought of as the fraction of nominal income (the price level P multiplied by real output y) held by individuals as money balances in a given time period. It is by definition the inverse of velocity (V):

φ≡1/V

Setting equal the supply and demand of money yields M*=φPy; substituting in the definition of fluidity and multiplying both sides by V yields the familiar quantity theory equation:

M*V=Py

Some Market Monetarists, Scott Sumner being the most notable, have called for a nominal income target, level targeting, with nominal income growing at five percent per year. This too is consistent with maintaining monetary equilibrium since the above equality also holds, conditional upon the correct expectations of market actors, in its dynamic form:

%∆M*+%∆V=%∆P+%∆y

%∆X means “The percentage change in Variable X per time period.” In the above equation the combined growth rate of P and y would, in Sumner’s world, equal five percent. Conditional upon constant velocity, this means supplying relatively less additional money when real output increases relatively more.

Stabilizing nominal income (Py or its growth rate) means supplying more money when the velocity of money falls (and hence fluidity rises, meaning money demand rises) and doing the opposite when the velocity of money rises. This has the advantage of stabilizing the purchasing power of money in the event of monetary disequilibrium (disequilibrium in the money market) while still allowing price fluctuations due to changing real factors which reflect relative scarcity. (This latter point is the key advantage nominal income targeting has over price level targeting.)

In other words, a nominal income target yields the stability necessary for rational economic calculation without the distortions which monetary disequilibrium causes and otherwise could only be corrected by a market-wide reallocation of misused resources, which is bound to include unnecessary unemployment and reduced production.

…And a Bag of Chips
Many Austrians and Austrian-influenced economists view Market Monetarism favorably due to its emphasis on maintaining a stable monetary framework, which means making money as neutral as it possibly can be. Of course, there are always going to be small distortions in relative prices depending on the injection point. The central bank by its very nature is an imperfect institution and lacks the incomprehensibly large stock of knowledge necessary to implement perfectly a policy of absolute monetary neutrality. Many Austrians’ support of free banking, mine included, as a first-best alternative to a central bank is in part motivated by the versatility and robustness of a decentralized versus centralized banking system. In addition, public choice considerations may also cut against having a central bank.

Nevertheless, an explicit static or dynamic nominal income target would be a massive improvement over the current state of affairs and is closer to being a feasible point on the policy possibilities frontier. The key point to take away from all this is that the Austrian conception of the market process and the importance of economic calculation leads naturally to the desirability of maintaining a stable monetary framework. Although there is certainly debate over which institutions best promote monetary equilibrium, Market Monetarists and sympathetic Austrians have a clear common ground and there is much we can learn from each other going forward.

————————————————————————

Lars Christensen

I am very happy that that Alex has accepted my invitation to write a guest blog on marketmonetarist.com. Alex’s excellent and insightful post shows that Austrians and Market Monetarists indeed share many views and I hope to continue the dialogue with open-minded Austrians like Alex in the future.

Furthermore I am happy to invite others who want to discuss the merits of Market Monetarism to contribute with guest blogs here on this blog and I hope that Alex also in the future will share his views on both the development of the Austrian school as well as on Market Monetarism.

 

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14 Comments

  1. Great Post! Look forward to more posts giving an Austrian perspective on Market Monetarism.

    It is my perception that most Austrians these days seem to be from the Rothbardian camp and do not accept MET and reject that ATBC itself is a specific type of monetary disequilibrium.

    Do you agree with this perceptions of do you think that the Mises Institute is misrepresenting a lot of Austrian thinking in this area ?

    Reply
    • Alex Salter

       /  October 14, 2011

      Hi Rob,

      In terms of numbers, I think non-Rothbardians outnumber Rothbardians in the academy. The Rothbardians are quite vocal, however, so it seems like they are more numerous.

      I’ve read Rothbard and modern-day Rothbardians on money and banking and I think they’re not as radical as some might think. They seem to have backed down from the “Fractional reserve banking is fraud!” claim somewhat; some, such as Jeffrey Tucker of the Mises Institute, think that 100% reserve banking would simply outcompete fractional reserve banking in a deregulated banking environment. I don’t think the historical record supports this, however.

      Ultimately, I’m hesitant to speak for Rothbardians since I’m not one myself and I’m not sure what definitively makes one a Rothbardian vs. non-Rothbardian, although I’d hazard a guess it has something to do with how closely one follows Mises. I don’t know their particular views on MET, but I feel confident in saying the conception of MET I wrote about is pretty solidly in the Wicksell-Mises-Hayek-Yeager-Selgin/White line. Also, I don’t think Mises Institutes are misrepresenting Austrian economics. Like I said, there are many differences in belief within Austrian economics; they represent their particular strand, as opposed to the strand at GMU for example.

      Hope this helps!

      Reply
  2. David Beckworth

     /  October 14, 2011

    Alex,

    I studied under George Selgin and thus have some Austrian roots. He was the one the introduced me to nominal income targeting, MET (had me read Yeager), and of course free banking. His influence can be seen in this article I wrote for the Cato Journal: http://www.cato.org/pubs/journal/cj28n3/cj28n3-1.pdf

    Anyways, I am glad to to see this conversation started between Austrians and Market Monetarists.

    Reply
    • Alex Salter

       /  October 14, 2011

      Hi David,

      Larry White actually introduced me to MET and NGDP targeting, and from him I branched out and read Selgin. There’s definitely a lot of intellectual firepower there.

      Thanks for the link to your Cato piece! I’ll take a look at it as soon as I can. I too am glad Austrians and Market Monetarists can have a conversation about MET and monetary policy. Rumors of our irrelevance have been greatly exaggerated!

      Reply
  3. Benjamin Cole

     /  October 14, 2011

    I will embrace the “Austrians” if they could pick the name of some less creepy nation–how about “Italians” –and agree for now we need to print a lot more money. And they forget about gold.

    Really, “Austrians”. Visions of jodhpurs and jackboots, and men who have involuntary arm spasms when they hear martial music, Dueling scars.

    Reply
  4. Rob

     /  October 14, 2011

    Very interesting (and Austrian 🙂 ) article that David.links to.

    I have a question on it though: Most Market Monetarists talk about getting NGDP back to its long-term growth trend, which is normally stated as being around 5%, of which 2% is for inflation-expectations and 3% for productivity growth.

    I am attempting to reconcile this with the views expressed in the article: How big a long term problem would we create by not allowing productivity growth to be reflected in lower prices? Can one assume that as long as the 3% built into the NGDP-target for productivity growth is built into people’s expectation that the sub-optimal side-effects would be avoided ?

    Reply
  5. Rob, excellent question.

    In my view what Alex is suggesting is George Selgin’s “productivity norm”. I would be very happy to address the issue, but we need more space so I will try to address it in a couple of posts in the near future.

    Until then take a look at what the “guru” Scott Sumner has to say about the “productivity norm”: http://www.themoneyillusion.com/?p=3059

    Reply
    • Rob

       /  October 15, 2011

      I was very interested to read that Sumner is (broadly) in agreement with Selgin “productivity norm” thinking.

      Obviously to strictly apply the norm in today’s conditions would involve setting a 0% NGDP-target which would require a tightening of monetary conditions and be a non-starter as a policy suggestion.

      Sumner says:

      “In principle, a productivity norm does not have to aim for mild deflation. You could target nominal wages to grow at 2% per year. In that case inflation would average about zero percent, but the actually rate of inflation would vary inversely with labor productivity shocks. ”

      This really sounds pretty much like what would happen anyway under NGDP_targeting (with 2% inflation rather than zero from Sumner’s example) and makes we wonders (especially given its emphasis on expectations) if the productivity norm is not already implicit in market monetarist thinking.

      I would definitely welcome more articles in this area because in my opinion once we are out of the current crises a key issue will be around what the optimum target should be to avoid these scenarios emerging in the future.

      Also would love some articles on Free Banking itself.

      Reply
  6. Rob, happy to hear that.

    I think the important difference is what would be appropriate monetary policy right now in the US and what would be a theoretical good REGIME. I personally have a lot of sympathy for Selgin’s productivity norm, but I would argue that if that where to be implemented in the US then the monetary disequilibrium would have to be take care before hand.

    I however is also interested in the theoretical discussion and I would like to have none-US centric view. Lets ask the question would the productivity norm be good for for example Turkey right now? I think it would…

    Reply
  7. …and to continue. Let say we are in a world of no institutional constrains and the economy more or less being in equilibrium. Then I guess most Market Monetarists would be in favour of something similiar to the productivity norm. At least I would…

    Reply
  8. “Consider an excess supply of money brought about by a central bank unnecessarily engaging in open market operations.

    This intervention gives an advantage to the first recipient of the new money relative to all other market actors, and the first recipient’s spending on his or her preferred consumption bundle creates a (admittedly very small) distortion in relative prices.”

    Would Scott Sumner agree with this?

    Reply
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