All posts for the month October, 2011

Chuck Norris on monetary policy #1

In the coming time I will pay tribute to the great Chuck Norris by analyzing the monetary policy implications of some well-known facts and quotes from the great hero. These “facts” all come from www.chucknorrisfacts.com

“Chuck Norris does not earn money,he prints it”

Well Chuck, so does central banks and that is why we can always avoid deflation, increase inflation and get whatever growth rate of nominal GDP we would like. But not even Chuck can increase real GDP growth in the long run by printing money. Not even Chuck can defeat the long run vertical Phillips curve.

7 Comments
by Lars Christensen on October 16, 2011  •  Permalink
Posted in Chuck Norris
Tagged

Posted by Lars Christensen on October 16, 2011

https://marketmonetarist.com/2011/10/16/chuck-norris-on-monetary-policy-1/

Japan’s deflation story is not really a horror story

Many economists – including some Market Monetarists – tell the story about Japan’s economy as a true horror story and there is no doubt that Japan’s growth story for more than 15 years has not been too impressive – and it has certainly not been great to have been invested in Japanese stocks over last decade.

Some Market Monetarists are explaining Japan’s apparent weak economic performance with overly tight Japanese monetary policy, while others blame “zombie banks” and continued deleveraging after the bubble in to 1990s. I, however, increasingly think that these explanations are wrong for Japan.

Obviously, Japan has deflation because money demand growth consistently outpaces money supply growth. That’s pretty simple. That, however, does not necessarily have to be a problem in the long run if expectations have adjusted accordingly. The best indication that this has happened is that Japanese unemployment in fact is relatively low. So maybe what we are seeing in Japan is a version of George Selgin’s “productivity norm”. I am not saying Japanese monetary policy is fantastic, but it might not be worse than what we are seeing in the US and Europe.

The main reason Japan has low growth is demographics. If you adjust GDP growth for the growth (or rather the decline) in the labour force then one will see that the Japanese growth record really is not bad at all – especially taking into accord that Japan after all is a very high-income country.

Daniel Gros, whom I seldom agrees with (but do in this case), has done the math. He has looked Japanese growth over the last decade and compared to other industrialized countries. Here is Gros:

“Policymaking is often dominated by simple “lessons learned” from economic history. But the lesson learned from the case of Japan is largely a myth. The basis for the scare story about Japan is that its GDP has grown over the last decade at an average annual rate of only 0.6% compared to 1.7 % for the US. The difference is actually much smaller than often assumed, but at first sight a growth rate of 0.6 % qualifies as a lost decade…According to that standard, one could argue that a good part of Europe also “lost” the last decade, since Germany achieved about the same growth rates as Japan (0.6%) and Italy did even worse (0.2 %); only France and Spain performed somewhat better…But this picture of stagnation in many countries is misleading, because it leaves out an important factor, namely demography…How should one compare growth records among a group of similar, developed countries? The best measure is not overall GDP growth, but the growth of income per head of the working-age population (not per capita). This last element is important because only the working-age population represents an economy’s productive potential. If two countries achieve the same growth in average WAP income, one should conclude that both have been equally efficient in using their potential, even if their overall GDP growth rates differ…When one looks at GDP/WAP (defined as population aged 20-60), one gets a surprising result: Japan has actually done better than the US or most European countries over the last decade. The reason is simple: Japan’s overall growth rates have been quite low, but growth was achieved despite a rapidly shrinking working-age population…The difference between Japan and the US is instructive here: in terms of overall GDP growth, it was about one percentage point, but larger in terms of the annual WAP growth rates – more than 1.5 percentage points, given that the US working-age population grew by 0.8%, whereas Japan’s has been shrinking at about the same rate.”

So it is correct that Japanese monetary policy was overly tight after the Japanese bubble bursted in the mid-90ties, but that is primarily a story of the 90s, while the story over the last decade is primarily a story of bad demographics.

We can learn a lot from Japan, but I think Japan is often used as an example of all kind of illnesses, but few of those people who pull “the Japan-card” really have studied Japan. Similar for me – I am not expert on the Japanese economy – but both the monetary and the deleveraging explanations for Japan’s low growth during the past decade (not the 90ties) I believe to be wrong.

The Great Depression as well as the Great Recession are terrible examples of the disasters that the wrong monetary policy can bring and so is the Japan crisis in the mid-90s, but we need to make the right arguments for the right policies based on fact and not myth.

PS in Daniel Gros’ comment on Japan he makes some comments on the effectiveness of monetary policy. He seems to think that monetary policy is impotent in the present situation. I strongly disagree with that as I believe that monetary policy is in fact very effective in increasing nominal income growth as well as inflation. The liquidity trap is a myth in the same way the Japan growth story is a myth.

9 Comments
by Lars Christensen on October 16, 2011  •  Permalink
Posted in Economic and monetary history, MM Research agenda, Monetary policy, Reading recommendations

Posted by Lars Christensen on October 16, 2011

https://marketmonetarist.com/2011/10/16/japan%e2%80%99s-deflation-story-is-not-really-a-horror-story/

”Recessions are always and everywhere a monetary phenomena”

At the core of Market Monetarist thinking, as in traditional monetarism, is the maxim that “money matters”. Hence, Market Monetarists share the view that inflation is always and everywhere a monetary phenomenon. However, it should also be noted that the focus of Market Monetarists has not been as much on inflation (risks) as on the cause of recession, as the starting point for the school has been the outbreak of the Great Recession.

Market Monetarists generally describe recessions within a Monetary Disequilibrium Theory framework in line with what has been outline by orthodox monetarists such as Leland Yeager and Clark Warburton. David Laidler has also been important in shaping the views of Market Monetarists (particularly Nick Rowe) on the causes of recessions and the general monetary transmission mechanism.

The starting point in monetary analysis is that money is a unique good. Here is how Nick Rowe describes that unique good.

“If there are n goods, including one called “money”, we do not have one big market where all n goods are traded with n excess demands whose values must sum to zero. We might call that good “money”, but it wouldn’t be money. It might be the medium of account, with a price set at one; but it is not the medium of exchange. All goods are means of payment in a world where all goods can be traded against all goods in one big centralised market. You can pay for anything with anything. In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.”

From this also comes the Market Monetarist theory of recessions. Rowe continues:

“Each market has two excess demands. The value of the excess demand (supply) for the non-money good must equal the excess supply (demand) for money in that market. That’s true for each individual (assuming no fat fingers) and must be true when we sum across individuals in a particular market. Summing across all n-1 markets, the sum of the values of the n-1 excess supplies of the non-money goods must equal the sum of the n-1 excess demands for money.”

Said in another way, recession is always and everywhere a monetary phenomenon in the same way as inflation is. Rowe again:

“Monetary Disequilibrium Theory says that a general glut of newly produced goods can only be matched by an excess demand for money.”

This also means that as long as the monetary authorities ensure that any increase in money demand is matched one to one by an increase in the money supply nominal GDP will remain stable (Market Monetarists obviously does not say that economic activity cannot drop as a result of a bad harvest or an earthquake, but such “events” does not create a general glut of goods and labour). This view is at the core of Market Monetarist’s recommendations on the conduct of monetary policy.

Obviously, if all prices and wages were fully flexible, then any imbalance between money supply and money demand would be corrected by immediate changes prices and wages. However, Market Monetarists acknowledge, as New Keynesians do, that prices and wages are sticky.

PS I inspired Nick Rowe to do a post on ”Recessions are always and everywhere a monetary phenomena”. Now I am stealing it back. Nick, I hope you can forgive me.

7 Comments
by Lars Christensen on October 16, 2011  •  Permalink
Posted in Economic and monetary history, General economic theory, Monetary policy, Nick Rowe, The Great Recession
Tagged , , , , ,

Posted by Lars Christensen on October 16, 2011

https://marketmonetarist.com/2011/10/16/recessions-are-always-and-everywhere-a-monetary-phenomenon/

Gustav Cassel on recessions

Swedish economist Gustav Cassel (1866-1945) had many views today is shared by Market Monetarism. I today was reminded by a Cassel quote that pretty much spells out the Market Monetarist view of the causes of recessions:

“(Recessions) are essentially a result of a supply of money that is too small, and to that extent are monetary phenomena…Complaints about excessive habits of saving are in such circumstances calculated to confuse the mind of the public and to distract attention from the shortcomings of monetary policy.”


- Gustav Cassel, Theory of Social Economy, 1918.

Cassel’s quote is an explanation for the Great Depression as well as for the Great Recession.

This is not the only area in which Market Monetarist can be inspired by and learn from Gustav Cassel. An obvious example is Gustav Cassel’s views on the Great Depression.

8 Comments
by Lars Christensen on October 15, 2011  •  Permalink
Posted in Economic and monetary history, General economic theory, Monetary policy, Reading recommendations, The Great Depression, The Great Recession

Posted by Lars Christensen on October 15, 2011

https://marketmonetarist.com/2011/10/15/gustav-cassel-on-recessions/

Never underestimate the importance of luck

The financial media is full of stories about some countries are doing the right thing and other are doing the wrong thing. Everybody today agree that it was obvious that the Icelandic financial system was going to collapse and everybody agrees that Greek’s economic problems could have been forecasted easily. I actually think that both cases were pretty obvious examples of accidents waiting to happen and the only reason that they did not play out earlier was investors where betting on some kind of rescue if we would see a collapse. However, it is not always so clear. Why for example has Belgium with very high public debt not been as hard hits by the European debt crisis as for example Italy or Spain? We can surely find explanations, but many of these explanations have to do with pure luck rather than fantastic skills of policy makers.

How often have we heard Finance Ministers around the world blame their countries’ bad economic situation on “the international crisis” – “it is out of hands and we can’t do anything”. On the other hand when things are fine policy makers will happily claim that things are fine thanks to their fantastic policies. An example of this is Poland’s rather remarkable escape from recession in 2009. Poland was the only country in Europe to grow in 2009 and Poland’s Finance Minister Jacek Rostowski happily declared that Poland was “immune to the crisis”. The fact, however, is that a key reason for Poland’s relatively strong economic performance was the near halving of the value of the zloty during the first half of 2009.

Another example is the Icelandic economic and financial collapse. In 2001-2 the Icelandic banking sector was deregulated, privatized and opened up. That of course coincided with a significant increase in global risk appetite, which made it possible for the Icelandic banks to expand their balance sheets to an unprecedented level of around 10 times Iceland’s GDP (mostly outside of Iceland). So when crisis hit in 2008 the whole thing came crashing down and Iceland is now widely believed to be an “irresponsible” nation like Greece. But the fact is that the things might have been very different had Iceland been a bit luckier as a nation then things would have been very different. Lets imagine that the deregulation and privatization of the Icelandic sector had happened five years later in 2006-7. Then the Icelandic banking sector would likely never have expanded its operations and foreign currency loans would never had become widespread. In that scenario the Icelandic banking sector might have been an example to the world of a prudent and conservative banking sector – a typical Nordic banking sector – and Iceland might not even had entered recession.

In Milton Friedman’s wonderful little book “Money Mischief” he tells the story of two countries with “identical policies”, but “opposite outcomes”. Both Israel and Chile introduced fixed exchange rate policies against the dollar. In Chile in 1979 and in Israel in 1985. For Israel it was a massive success, but for Chile it was a disaster. Chile pegged the peso to the dollar at a period, which coincided with a strengthening of a dollar and a collapse in copper prices (Chile’s main export). So Chile was hit by a both a monetary policy shock (the stronger dollar) and a supply shock (the drop in copper prices) just as the peg was introduced. For Israel the opposite happened – the shekel was pegged to the dollar at a time when the dollar was weakening. The differences in the “external environment” had a great impact on how well the experiment with exchange rate policies impacted growth. Chile went into recession, while Israel grew nicely.

The stories from Chile and Israel as well as from Poland and Iceland are reminders of what Friedman tells us in “Monetary Mischief” (Chapter 9): “Never underestimate the role of luck in the fate of individuals or of nations”. So next time you celebrate how clever an investor you are or you think of the Greeks as lazy and irresponsible. Remember what Friedman told us – it is often just about luck or the opposite.

5 Comments
by Lars Christensen on October 15, 2011  •  Permalink
Posted in Luck, Uncategorized

Posted by Lars Christensen on October 15, 2011

https://marketmonetarist.com/2011/10/15/never-underestimate-the-importance-of-luck/

Horwitz, McCallum and Markets (and nothing about Rush)

Alex Salter has made a forceful argument that there are strong theoretical similarities between Market Monetarist thinking and Austrian School Monetary Equilibrium Theorists (MET). I on my part have noted that METs like Steven Horwitz have similar policy recommendations as Market Monetarists – particularly NGDP targeting.

Steve Horwitz makes a strong case for NGDP targeting (and ultimately Free Banking) in his excellent book“Microfoundations and Macroeconomics: An Austrian Perspective”.

I have earlier suggested that a modified version of the so-called McCallum rule to implement NGDP target. Here is Steve’s take on the McCallum rule:

“Of particular interest is the rule proposed by Bennett McCallum (1987). He explicitly argues that the monetary authority should adopt a rule that targets a stable level of nominal income. Given the equation of exchange, such a rule amounts to maintaining monetary equilibrium by stabilizing MV. Unlike a Friedman-type rule, McCallum’s proposal would allow the monetary authority to adjust the monetary base as needed to offset changes in payments technology and the like. McCallum’s proposal also requires that the monetary authority make a guess at what the future growth rate in real GDP will be in order to know at what rate to change the base. This particular rule has several advantages, mainly that it does take complete discretion away from the monetary authority and it does bind it to the attempt to maintain monetary equilibrium.”

So far so good, but Steve has some highly relevant objections:

“However, it faces the same sorts of problems that plague central banking in general: can it know with certainty what the growth rate in real GDP will be and can it know exactly how changes in the monetary base will translate into changes in the overall supply of money? Even though the central bank is being bound to a rule, it still must possess a great deal of information, centralized in one place, in order to be able to execute the rule effectively.”

Hence, the McCallum rule might be an overall good starting point, but it is essentially backward-looking and we can not forecast future NGDP based on “centralized information” like a central bank try to do, but rather our monetary regime should be based on “decentralized information” and that is why Steve prefers a privatization of the supply of money – aka Free Banking.

This is pretty much in the spirit of the Market Monetarist’s dictum that money matters and markets matter. But what if the central bank’s monopoly on the supply of money is maintained? How do we ensure an outcome, which emulates the Free Banking outcome?

The obvious answer is to introduce a forward-looking version of the McCallum rule, where expectations for NGDP growth is based on market data – equity prices, commodity prices, bond yields and the currency. The best solution obviously would be a future markets for NGDP, but since that does not exist a second best solution is to estimate NGDP expectations on other market prices.

I have earlier suggested such a modified version of the McCallum rule, but I not entire happy with how that came out, but nonetheless I think it beneficial for Market Monetarist research to focus on the empirical relationship between NGDP, the expectations for monetary policy and policy rules.

Challenge for aspiring Market Monetarist econometricians: Estimate a VAR system based on NGDP, the money base (MZM), velocity and S&P500 (as a measure of market expectations) with US data for the period 1985-2007. Use the model to simulate money base growth from early 2008 and until today and compare this “optimal” money base growth with the actual growth in the money. This could provide empirical support for or against the Sumnerian thesis that the Fed caused the Great Recession.

2 Comments
by Lars Christensen on October 15, 2011  •  Permalink
Posted in Austrian economics, Financial markets, MM Research agenda, Monetary policy, Reading recommendations
Tagged

Posted by Lars Christensen on October 15, 2011

https://marketmonetarist.com/2011/10/15/horwitz-mccallum-and-markets-and-nothing-about-rush/

Market Monetarism – now on Wikipedia

Believe it or not – “Market Monetarism” i now on Wikipedia. I have no clue who is behind it, but as far as I can read most of the text makes perfectly good sense. That said, it needs a bit more work…

I will happily volunteer my paper on working paper on “Market Monetarism: The Second Monetarist Counter-revolution” for those who are updating the Wiki text…and I will be happy to allow you to “steal” a bit of text from my working paper – yeah you can even get me the Word file if you like (drop me a mail at lacsen@gmail.com).

I guess this means that Market Monetarism is not a complete fringe school of thought anymore.

…….

UPDATE: I have been told that the market monetarism wiki article is being “considered for deletion”. I have no clue why that is, but obviously that would be sad to see. It is obvious that some people have been putting in an effort to get “market monetarism” on Wikipedia and to me it looks like an objective and fair description of what market monetarism is about. If you want to you might get involved in “defending” the article.

1 Comment
by Lars Christensen on October 14, 2011  •  Permalink
Posted in MM Research agenda, Reading recommendations

Posted by Lars Christensen on October 14, 2011

https://marketmonetarist.com/2011/10/14/market-monetarism-now-on-wikipedia/

Reagan supply siders = market monetarists?

I have noticed that a increasing number of 1980s US supply siders are coming out views on US monetary policy which is very close to the Market Monetarist views. This is not really surprising if one studies what the supply siders were saying in the 80s, but it is nonetheless in stark contrast to the core views of today’s GOP.

A good example is Nobel laureate Bob Mundell who recently at a Heritage Foundation seminar gave a Market Monetarist  explanation for the Great Depression: The Fed caused it.

The latest Reagan supply sider to come out with a market monetarist perspective on monetary policy is Bruce Bartlett.

See this the Bartlett’s interview on CNBC here in which he calls for the Federal Reserve to implement a nominal GDP target.

PS David Beckworth has a much more clever comment on Bartlett.

1 Comment
by Lars Christensen on October 14, 2011  •  Permalink
Posted in Monetary policy, Reading recommendations

Posted by Lars Christensen on October 14, 2011

https://marketmonetarist.com/2011/10/14/reagan-supply-siders-market-monetarists/

Rush, Rush, Market Monetarists, Steven Horwitz is your friend

Do you remember the Canadian rock band Rush? Steven Horwitz does. Steven does not only like odd Canadian rock, but he is also a clever Austrian school economist. Reading Alex Salter’s guest blog (“An Austrian Perspective on Market Monetarism”) imitiately made me think of Steven.

Steven Horwitz identify himself as a Austrian economist in the monetary equilibrium (ME) tradition. Market Montarists like Bill Woolsey and David Beckworth in many way share the theoretical background for this tradition with dates back to especially Leland Yeager and to some extent Clark Warburton (who by the way both termed themselves “monetarists” rather than “Austrians”).

Steven has co-authored a paper on the reasons for the Great Recession with William J. Luther:

“The Great Recession and its Aftermath from a Monetary Equilibrium Theory Perspective”

Here is the abstract for you:

“Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. It is from this latter perspective that we consider the events of the last few years. We argue that the primary source of business fluctuation is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescription to reduce the likelihood that such a scenario occurs again by better ensuring monetary equilibrium and eliminating moral hazard.”

I find Steven’s and Bill’s paper interesting in many ways. One of the things that strikes me is how close it is to the “journey” towards Market Monetarism described so well by David Beckworth in his recent post. See my own “journey” here.

The story basically is the following: Monetary policy was overly easy in the US prior to the crisis, but that in itself was not the only problem. Equally important was (is) the massive extent of moral hazard not only in the US, but also in Europe. But while US monetary policy was overly loose prior to the crisis it became overly tight going into the crisis and that caused the Great Recession.

I will not review the entire paper, but lets zoom in on the policy recommendations in the paper. Steven and Bill write:

“…one thing policymakers can do is ensure that, when enough time has passed, market participants will return to an institutional environment conducive to the market process. This requires addressing two major problems moving forward: monetary instability and moral hazard…In our view, monetary stability means continuously adjusting the supply of money to offset changes in velocity. Given the current monetary regime, where such adjustments are in the hands of the central bank, they should be made as mechanical as possible. Discretionary monetary policy unnecessarily introduces instability into the system with little or no offsetting benefit. Instead, the Fed should commit to a policy rule. Given our monetary equilibrium view, we hold that the Fed should adopt a nominal income target. Although nominal income targeting would require price adjustments in response to changes in aggregate supply, these particular price changes convey important information about relative scarcity over time and would be much less costly than requiring all other prices to change as would be the case under a price-level targeting regime… Under a nominal income targeting regime, monetary policy would have the best chance to maintain our goal of monetary equilibrium, at least to the extent that central bankers can accurately estimate and commit to follow an aggregate measure of output. As imperfect as this solution would be, we believe it is superior to the alternatives available in the world of the second best, and certainly an improvement over the status quo of the Fed’s pure discretion in monetary policy and beyond.

…A monetary regime that stayed closer to monetary equilibrium would have likely prevented the housing bubble and subsequent recession. However, it is also important to weed out the moral hazard problem perpetuated—and recently exacerbated—by nearly a century of policy errors. Among other things, this means ending federal deposit insurance and credibly committing not to offer any more bailouts. The political consequences of such a policy are admittedly unclear. And the feasibility of credibly committing to refrain from stepping in should a similar situation result, having just exemplified a willingness to do precisely the opposite, does not look promising. Nonetheless, we contend that ending the moral hazard problem is essential to long-run economic growth free of damaging macroeconomic fluctuations.

…The absolute worst solution in terms of dealing with moral hazard would be to abolish these programs officially without credibly committing to refrain from reestablishing them in the future. If market participants expect the government will bail them out when they get into trouble, they will act accordingly. The difference, however, would be that the Deposit Insurance Fund—having been abolished—would be empty and the full cost of bailing out depositors would fall on taxpayers in general. If bailouts and deposit insurance are going to be offered in the future, those likely to take advantage of them should be required to pay into respective funds to be used when the occasion arises. Ideally, payouts would be limited to the size of the fund. But given that a lack of credibility is the only acceptable reason to perpetuate these programs, their continuance suggests that the resulting government would be unable to tie its hands in this capacity as well.”

Cool isn’t it? I think there is good reason to expect Market Monetarists and Austrians like Steven and Alex to have a very meaningful dialogue about monetary theory and policies.

PS If you want to identify some differences of opinion among Market Monetarist bloggers ask them about US monetary policy prior to the outbreak of the Great Depression. David Beckworth would argue that US monetary policy indeed was too loose prior to the crisis, while Scott Sumner would argue that that might have been the case, but that is largely irrelevant to the present situation. My own views are somewhere in between.

PPS Steve, you are right Rush is pretty cool. This is “The Trees”.

13 Comments
by Lars Christensen on October 14, 2011  •  Permalink
Posted in Austrian economics, General economic theory, MM Research agenda, Monetary policy, Reading recommendations, Steven Horwitz, The Great Recession
Tagged

Posted by Lars Christensen on October 14, 2011

https://marketmonetarist.com/2011/10/14/rush-rush-market-monetarists-steven-horwitz-is-your-friend/

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.

 

14 Comments
by Lars Christensen on October 13, 2011  •  Permalink
Posted in Austrian economics, General economic theory, Guest blog

Posted by Lars Christensen on October 13, 2011

https://marketmonetarist.com/2011/10/13/guest-blog-an-austrian-perspective-on-market-monetarism/

« Older Posts
Newer Posts »