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…
Steve Horwitz
/ February 26, 2012I’ll just add that the point of my book was to bring Yeager, Warburton, and the Austrians all under one umbrella, so it isn’t surprising that you see the first two in there, but I don’t think they’re there “more” than the Austrians (maybe more than Rothbard of AGD, but certainly not Mises and Hayek).
Lars Christensen
/ February 26, 2012Steve, thank you for your comment. You know I love Yeager as much as you do so I basically just wanted to once again thank you for bringing him into the discussion in your book. You will be happy to hear that I highly recommend your book to the young Austrians at yesterday’s conference.
And ok, you give plenty of space to Mises and Hayek – as I would be happy to do.
Btw you spend less time on Warburton than on Yeager in you book. That is no surprise to me, but I would very interesting in hearing your take on Warburton. Maybe I could challenge you to write a post on your blog on Warburton – then I will write something on Yeager;-)
Diego Espinosa
/ February 26, 2012Isn’t Austrian theory essentially an explanation of the credit-cycle behavior of “V” in the equation of exchange?
Monetarists made the mistake of assuming that V was more or less constant. MM’s assume it can be made constant through central bank expectations-setting. Austrians would argue that making it constant leads to the build-up of risk, fragility and, ultimately, a crisis.
Is the character and intensity of financial intermediation an AS or AD issue? Can the Fed control it — induce a Great Moderation — without creating more systemic risk? I don’t see why Market Monetarism is incompatible with Austrian answers to these questions. For instance, how would the Fed prevent a build up of systemic risk during the next “Great Moderation”? Answering this question is preferable, IMO, to arguing, “systemic risk was not the problem in the first place.”
Lars Christensen
/ February 26, 2012Diego,
“Isn’t Austrian theory essentially an explanation of the credit-cycle behavior of “V” in the equation of exchange?”
Well, if that is the case then it is totally comparable with Market Monetarism and some Austrians might think of ABCT in that way. That said, I would argue the Rothbard and today’s “internet Austrians” think in terms of a national account identity rather in term of MV=PY.
Lee Kelly
/ February 26, 2012Austrians tend to argue that distortions created by an excess supply of money (inflationary boom) can only be properly undone when followed by an excess demand for money (deflationary bust). Attempts to prevent the deflationary bust will, supposedly, just prop up unsustainable patterns of spending and prices, i.e. malinvestment.
In my opinion, this is really the difference between good and bad Austrians–Austrians like Horwitz don’t make this mistake.
JP Koning
/ February 27, 2012“The starting point of macroeconomic analysis should not be (1), but rather the equation of exchange”
What about the 2001 tech collapse-inspired recession? How does MV=PY explain that better than Y=C+I+G?
Lars Christensen
/ February 27, 2012JPK,
Well, I think that goes equally well for 2001. In fact the recession became relatively mild exactly because the Fed acted to counteract the drop in velocity on back of the bursting of the tech bubble (yes, I believe it was a bubble which partly was sparked by overly easy monetary policy from 1998-99).
JP Koning
/ February 27, 2012Did tight money cause the NASDAQ to finally peak in April 2000 taking the rest of the economy with it? If money hadn’t become tight, do you think the tech boom would have continued? I’m trying to test you on how far you want to take “recessions are always and everywhere a monetary phenomenon.” I don’t think I’d be alone in finding many examples demonstrating the non-nominal character of the 1998-2002 period and its wild range of movements.
Lars Christensen
/ February 27, 2012JPK,
I would actually like to return to this issue because it is extremely interesting – and my series on US monetary history through a Quasi-Real Price perspective has not been finished – I still need a couple of decades.
That said, I will give you a bit of answer. I would not rule out that the NASDAQ bubble was non-monetary in its nature (even though I think easy money played some role). However, I would argue that the recession that followed clearly was monetary. That said, the Fed of 2001-2002 did a much better job than the Fed of today.
JP Koning
/ February 27, 2012Look forward to it.
Jonathan M.F. Catalán
/ February 28, 2012Lars,
With regards to the Austrian theory, I think you’re wrong in your characterization of it. If you read Hayek’s Prices and Production money plays the most important role in the business cycle. The loanable funds market’s interest rate is relevant in enticing borrowing by entrepreneurs, but what magnifies the distortions are the changes in the relative prices between goods of different orders — distortions ultimately caused by the circulation of money, not directly by interest rates.
In a simple case, we see entrepreneurs increase quantity demanded for credit due to a fall in the rate of interest. They see that there are profitable opportunities by producing more consumer goods (if P =/= MC then there are still profitable opportunities) and so they increase investment in this stage of production. An increase in production here, though, is going to require an increase in the purchase of (demand for) inputs (producers’ goods of the next order), and so investment in this stage of production increases. Thus we see an increase in production down the structure until profit margins between stages go to zero.
This is why, in my opinion, so many Austrians (including myself) don’t see merit in the “tight money” theory. There are those who disagree (Horwitz, Selgin, etc.), but even then, I would say, are in favor of a “tighter” monetary regime than many other monetarists (all this is relative — relative to Rothbardians, they would be in favor of a “loose money” policy, of course).
So, no, it is not a theory that focuses only on output. The Austrian theory is very much a monetary one — it looks at how changes in the circulation of money affect the structure of production.
Lars Christensen
/ February 28, 2012Jon,
Thank you for your comments. I must admit that I often have a hard time figuring out what the Austrians really think of business cycle theory. Maybe it is because I simply turn of my brain when the story of Austrian capital theory emerges. No ok, I am foolish – I do think I kind of understand Austrian capital theory, but Price and Production was not a good description of the business cycle and I think Hayek later in life gave up on that theory. It didn’t work. When I many years ago wrote my master thesis on ABCT I tried to mathematically formalize PaP. It did not really work – or rather the theory of logically flawed.
But ok I will admit that I am hard on the Austrians and I will admit that I often fail to grasp the details. I do understand 100% of what Horwitz is saying he makes completely sense to me and of course Selgin make a lot of sense. But hey George is no Austrian (George is Geroge and if you are as clever and smart as George you don’t need any schools…). If he is an Austrian – then I am an Austrian as well.
Sorry, if this come across as insulting in anyway. It is certainly not meant to insulting. Rather I very much appreciate your feedback – after all I do consider the Austrians (with a few exceptions) as family.
Rob
/ February 28, 2012I don’t think there is any conflict at all between Market Monetarism and Austrian ABCT.
The ABCT is fundamentally a theory of the distortions that arise when the central bank allows the money supply to rise above its equilibrium level (for the current price level). An NGDP Targeting central bank would not be able to expand the money supply in that way.
And during the bust phase a CB that adopted NGDP targeting central bank would be able to prevent the “secondary deflation” that Hayek identified and allow the necessary “liquidations” to proceed in an optimal way.
So while Market Monetarists may or not accept ABCT there is no reason (in my view) for Austrian believers in ABCT to reject Market Monetarism (beyond a phobia of central banking.)
Lars Christensen
/ February 28, 2012Rob,
I think you are right. If the ABCT is what Steve Horwitz then it is pretty similar to how I think bubble can under some circumstances emerge. I am sure that at least David Beckworth and Bill Woolsey would agree. Scott on the other hand would be skeptical about the bubble talk.
And yes, Hayek indeed seemed to support NGDP – and Selgin has even argued that Mises theoretically should have support NGDP targeting. So yes, in terms of policy recommendations that should not be any major disagreement between Austrians and Market Monetarists – and I fundamentally don’t think there is.
ronsardenprison
/ April 21, 2012Hello,
“It is notable that most people are not clear about whether Y is nominal or real GDP.”
I don’t see how the so-called “GDP” could be expressed in “real” terms, given that what this concept tries to measure — the consumer goods production — is devoided of any homogeneity, and, as consequence, cannot be aggregated.