All posts in category Austrian economics

Guest blog: Central banking – between planning and rules

I have asked Alex Salter to give his perspective on the ongoing debate about “Central banking is (not) central planning” in the blogosphere.

David Glasner also has a new comment on the subject.

But back to Alex…

……………

Guest blog:  Central banking – between planning and rules

Alex Salter
asalter2@gmu.edu

I’ve been reading about the central banking vs. central planning debate on the blogosphere; the more I think about it the more interesting it becomes. Whether central banking is a form of central planning depends on what exactly the central bank does.  There are two broad scenarios.  In the first, the central bank is following some sort of rule or trying to hit a target.  This can be a Taylor rule, inflation target, NGDP level target, or anything else.  In this case the central bank is trying to provide a stable economic setting so that individuals can effectively engage in the market process.  If this is what the central bank is doing, I don’t think it makes sense to call it central planning. All the central bank is trying to do is lay down the “ground rules” for economic behavior. If this is central planning, you could just as easily say any institution such as property rights or the rule of law is central planning too. This obviously isn’t a useful definition of central planning!

However, a central bank may be engaging in a type of central planning if it tries to bring about a specific allocation of resources.  For example, if the central bank thinks equities prices should be higher for some reason, and they start purchasing equities, you could make an argument that this is a type of central planning.  If the central bank explicitly tries to monetize the debt and acts as an enabler for the nation’s treasury department, you could also say this is a form of central planning.  It’s still not 100% clear, since presumably the central bank is not using coercion or the threat of coercion to get market participants to behave in the way it wants; there’s voluntary assent on the other side of the agreement, even if that voluntary assent is a response to warped incentives.

In closing: if a central bank is trying to create a specific framework in which agents can operate, it’s not central planning, it’s rule setting.  If on the other hand the central bank is trying to allocate specific resources, it may be a form of central planning.  In either scenario, the usual knowledge and incentive problems still apply.

15 Comments
by Lars Christensen on October 25, 2011  •  Permalink
Posted in Austrian economics, Guest blog, MM Research agenda, Monetary institutions
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Posted by Lars Christensen on October 25, 2011

https://marketmonetarist.com/2011/10/25/guest-blog-central-banking-between-planning-and-rules/

When central banking becomes central planning

The great thing about the blogosphere is that everything is happening in “real-time”. In economic journals the exchange of ideas and arguments can go on forever without getting to any real conclusion and some debates is never undertaken in the economic journals because of the format of journals.

Such a debate is the discussion about whether central banking is central planning, which has been going on between the one hand Kurt Schuler and on the other hand David Glasner and Bill Woolsey. Frankly speaking, I shouldn’t really get involved in this debate as the three gentlemen all are extreme knowledgeable about exactly this topic and they have all written extensively about Free Banking – something that I frankly has not written much about.

In my day-job central banks are just something we accept as a fact that is not up for debate. Anyway, I want to let me readers know about this interesting debate and maybe add a bit of my humble opinion as we go along. There is, however, no reason to “reprint” every single argument in the debate so here are the key links:

From Glasner:

“Gold and Ideology, continued”

“Central Banking is not Central Planning”

“Hayek on the meaning of planning”

“Central Banking and Central Planning, again”

From Schuler:

“Central Banking is a form of Central Planning”

“Once more: central banking is a form of central planning”

From Woolsey:

“Central Banking is Not Central Planning”

Initially my thinking was, yes, of course central banking is central planning, but Bill Woolsey arguments won the day (Sorry David, the Hayek quotes didn’t convince me…).

Here is Bill Woolsey:

“Comprehensive central planning of the economy is the central direction of the production and consumption of all goods services. How many cars do we want this year? How much steel is needed to produce those cars? How much iron ore is needed to produce the steel?…Trying to do this for every good and service all the time for millions of people producing and consuming is really, really hard. Perhaps impossible is not too strong of a word, though that really means impossible to do very well at all, much less do better than a competitive market system…Central banking is very different. It does involve having a monopoly over a very important good–base money. Early on, governments sold that monopoly to private firms, but later either explicitly nationalized the central banks, or regulated and “taxed” them to a point where any private elements are just window dressing…Schuler’s error is to identify this monopoly on the provision of an important good with comprehensive central planning. Yes, a monopolist must determine how much of its product to produce and what price to charge. The central bank must determine what quantity of base money to produce and what interest rate to pay (or charge) on reserve balances. But that is nothing like determining how much of each and every good is to be produced while making sure that the resources needed to produce them are properly delivered to the correct places at the correct times.”

Bill continues (here its gets really convincing…):

“Suppose electric power was produced as a government monopoly. That is certainly realistic. The inefficiency of multiple sets of transmission lines provides a plausible rationale. The government power monopoly would need to determine some pricing scheme and how much power to generate. And, of course, these decisions would have implications for the overall level of economic activity. Not enough capacity, and blackouts disrupt economic activity. Too much capacity, and the higher rates needed to pay for it deter economic activity…It is hard to conceive of an electric utility centrally directing the economy, but it isn’t impossible. Ration electricity to all firms based upon a comprehensive plan for what they should be doing. Any firm that produces the wrong amount and sends it to the wrong place is cut off.”

Central banking might not be central planning

Hence, there is a crucial difference between central planning and a government monopoly on the production of certain goods (as for example money). One can of course argue that if government produces anything it is socialism and therefore central planning. However, then central planning loses its meaning and will just become synonymous with socialism. Therefore, arguing that central banking is central planning as Schuler does is in my view wrong. It might be a integral part of an socialist economic system that money is monopolized, but that is still not the same thing as to say central banking is central planning.

But increasingly central banking is conducted as central planning

While central banking need not to be central banking it is also clear that during certain periods of history and in certain countries monetary policy has been conducted as if part (or actually being part of) a overall central planning scheme. In fact until the early 1980s most Western European economies and the US had massively regulated financial markets and credit and money were to a large extent allocated with central planning methods by the financial authorities and by the central banks. Furthermore, exchange controls meant that there was not a free flow of capital, which “necessitated” central planning of which companies and institutions should have access to foreign currency. Therefore, central banking during the 1970s for example clearly involved significant amounts of central planning.

However, the liberalization of the financial markets in most Western countries during the 1980s sharply reduced the elements of central planning in central banking around the world.

The Great Recession, however, has lead to a reversal of this trend away from “central bank planning” and central banks are increasingly involved in “micromanagement” and what clear feels and look like central planning.

In the US the Federal Reserve has been highly involved in buying “distressed assets” and hence strongly been influencing the relative prices in financial markets. In Europe the ECB has been actively interfering in the pricing of government bonds by actively buying for example Greek or Italian bonds to “support” the prices of these bonds. This obviously is not central banking, but central planning of financial markets. It is not and should not be the task of central banks to influence the allocation of credit and capital.

With central banks increasingly getting involved in micromanaging financial market prices and trying to decide what is the “right price” (contrary to the market price) the central banks obviously are facing the same challenges as any Soviet time central planning would face.

Mises and Hayek convincing won the Socialist calculation debate back in the 1920s and the collapse of communism once and for all proved the impossibility of a central planned economy. I am, however, afraid that central banks around the world have forgotten that lesson and increasing are acting as if it was not Mises and Hayek who prevailed in the Socialist-calculation debate but rather Lerner and Lange.

Furthermore, the central banks’ focus on micromanaging financial market prices is taking away attention from the actual conduct of monetary policy. This should also be a lesson for Market Monetarists who for example have supported quantitative easing in the US. The fact remains that what have been called QE in the US in fact does not have the purpose of increasing the money supply (to reduce monetary disequilibrium), but rather had the purpose of micromanaging financial market prices. Therefore, Market Monetarists should again and again stress that we support central bank actions to reduce monetary disequilibrium within a rule-based framework, but we object to any suggestion of the use  central planning “tools” in the conduct of monetary policy.

11 Comments
by Lars Christensen on October 23, 2011  •  Permalink
Posted in Austrian economics, Economic and monetary history, Free Banking, General economic theory, MM Research agenda, Monetary institutions, Monetary policy
Tagged , , , , , ,

Posted by Lars Christensen on October 23, 2011

https://marketmonetarist.com/2011/10/23/when-central-banking-becomes-central-planning/

Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

I always enjoy reading whatever George Selgin has to say about monetary theory and monetary policy and I mostly find myself in agreement with him.

George always is very positive towards the views of Milton Friedman, which is something I true enjoy as longtime Friedmanite. I particular like George’s 2008 paper “Milton Friedman and the Case against Currency Monopoly”, in which he describes Friedman’s transformation over the years from being in favour of activist monetary policy to becoming in favour of a constant growth rule for the money supply and then finally to a basically Free Banking view.

I believe that George’s arguments make a lot of sense I and I always thought of Milton Friedman as a much more radical libertarian than it is normally the perception. In my book (it’s in Danish – who will translate it into English?) on Friedman I make the argument that Friedman is a pragmatic revolutionary.

To radical libertarians like Murray Rothbard Milton Friedman seemed like a “pinko” who was compromising with the evil state. Friedman, however, did never compromise, but rather always presented his views in pragmatic fashion, but his ideas would ultimately have an revolutionary impact.

I there are two obvious examples of this. First Friedman’s proposal for a Negative Income Tax and second his proposal school vouchers. Both ideas have been bashed by Austrian school libertarians for compromising with the enemy and for accepting government involvement in education and “social welfare”. However, there is another way to see both proposals and is as privatization strategies. The first step towards the privatization of the production of educational and welfare services.

Furthermore, Friedman’s proposals also makes people think of the advantages if the freedom of choice and once people realize that school vouchers are preferable to a centrally planned school system then they might also realize that free choice as a general principle might be preferable.

In a similar sense one could argue that Scott Sumner and other Market Monetarists are pragmatic revolutionaries when they argue in favour of nominal GDP targeting.

Why is that? Well, it is a well-known result from the Free Banking literature that a privatization of the money supply will lead to money supply becoming perfectly elastic to changes in money demand. Said, in another way any drop in velocity will be accompanied by an “automatic” increase in the money, which effectively would mean that a Free Banking system would “target” nominal NGDP. Hence, as I have often stated NGDP targeting “emulates” a Free Banking outcome. In that sense Sumner’s proposal for NGDP targeting is similar to Friedman’s proposal for school vouchers. It is a step toward more freedom of choice. Scott therefore in many ways also is a pragmatic revolutionary as Friedman was.

There is, however, one crucial difference between Friedman and Sumner is that, while Friedman was in favour of a total privatization of the school system and just saw school vouchers as a step in that direction Scott does not (necessarily) favour Free Banking. Scott argues in favour of NGDP targeting based on its own merits and not as part of a privatization strategy. This is contrary to the Austrian NGDP targeting proponents like Steve Horwitz who clearly see NGDP targeting as a step towards Free Banking. Whether Scott favours Free Banking or not does, however, not change the fact that it might very well be seen as the first step towards the total privatization of the money supply.

Sumner’s proposal the implementation of NGDP futures could in a in similar fashion be seen as a integral part of the privatization of the money supply.

Friedman famously paraphrased the French Word War I Prime Minister George Clemenceau who said that “war is much too serious matter to be entrusted to the military” to “money is much too serious a mater to be entrusted to central banker”. Scott Sumner’s proposal for NGDP targeting within a NGDP futures framework in my view is the first step to taken away central bankers’ control of the money supply…but don’t tell that to the central bankers then they might never go along with NGDP Tageting in the first place.

For Scott own view of the Free Banking story see: “An idealistic defense of pragmatism” – he of course might as well have said “A revolutionary defense of pragmatism”.

———–

Update: I just found this fantastic quote from George Selgin (from comment section of Scott’s blog): ‘I only wish…that Scott would draw inspiration from Cato the Elder, andend each of his pleas for replacing current Fed practice with NGDP targeting with: “For the rest, I believe that the Federal Reserve System must ultimately be destroyed.”’

22 Comments
by Lars Christensen on October 23, 2011  •  Permalink
Posted in Austrian economics, Free Banking, MM Research agenda, Monetary institutions, NGDP Targeting, Reading recommendations
Tagged , , , , , , , , ,

Posted by Lars Christensen on October 23, 2011

https://marketmonetarist.com/2011/10/23/scott-sumner-and-the-case-against-currency-monopoly-or-how-to-privatize-the-fed/

Do you remember Friedman’s “plucking model”?

Clark Johnson’s paper on the Great Recession has reminded me of Milton Friedman’s so-called “Plucking model” as Johnson mentions Friedman original 1966 paper on the Plucking model. I haven’t thought of the Plucking model for some time, but it is indeed an important contribution to economic theory which in my view is somewhat under-appreciated.

At the core of the Plucking model is that the business cycle is asymmetrical. If you studies modern day textbooks on Macroeconomics it will talk about the “output gap” as it is something we can observe in the real world and a lot of econometric modeling is done under the assumption that real GDP move symmetrically around “potential GDP” over time.

The idea in the Plucking model is, however, that the business cycle really can’t be symmetrical as no economy can produce more than at full capacity. Hence, all shocks in the model will have to be negative shocks – or shocks to the potential GDP. Simply expressed negative shocks are demand shocks and positive shocks are supply shocks – and Friedman assumes that the demand shocks dominates.

A numbers of older and relatively new research confirms empirically the the Plucking model, but for some reason it is not getting a lot of attention.

A key implication of the Plucking model is that there is not correlation between the extent and the size of the “boom” prior to a crisis and how fast the recovery is afterwards. The implication of this is that the idea of “The New Normal” where we will have to have lower growth in the coming years because of “overspending” prior to the crisis simply does not find support in economic history.

Here is a recent interesting paper that finds empirical support for the Plucking model – including for the period covering the Great Recession.

Needless to say – Austrian business cycle fanatics do not agree with the conclusions in the Plucking model…

More research on the Plucking model would be interesting and it would be interesting to see how Market Monetarists can learn from the model.

5 Comments
by Lars Christensen on October 22, 2011  •  Permalink
Posted in Austrian economics, Economic and monetary history, MM Research agenda, The Great Recession
Tagged , , , ,

Posted by Lars Christensen on October 22, 2011

https://marketmonetarist.com/2011/10/22/do-you-remember-friedmans-plucking-model/

Open-minded Brits – and Austrians

American Alex Salter is a good example of the open-minded Austrians who has welcomed the dialogue with Market Monetarists. In my own part of the world Austrians is also engaging us in a serious fashion. A good example is Anthony Evans – self-declared Austrian, monetary specialist and Associate Professor of Economics at London’s ESCP Europe Business School, and Fulbright Scholar-in-Residence at San Jose State University.

Anthony is endorsing a NGDP target for the Bank of England. See his latest comment from City A.M. here. See also this earlier comment.

In general it is interesting how British monetarists as well as British Austrian school economists seem to be much more open to Market Monetarist ideas than their counterparts in the US and in continental Europe. In that regard it should be noted that the Bank of England probably is the central bank in the world that is taking NGDP targeting most serious.

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by Lars Christensen on October 19, 2011  •  Permalink
Posted in Austrian economics, MM Research agenda, Monetary policy, Reading recommendations
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Posted by Lars Christensen on October 19, 2011

https://marketmonetarist.com/2011/10/19/open-minded-brits-%e2%80%93-and-austrians/

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/

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/

Market Monetarist Methodology – Markets rather than econometric testing

When I wrote my book on Milton Friedman (sorry it is in Danish…) a decade ago I remember that the hardest chapter to write was the chapter on Friedman’s methodological views. It ended up being a tinny little chapter and I was never satisfied with it. The main reason was that even though I was and continue to be a Friedmanite in my general (macro) economic thinking I did not agree with Friedman methodological views.

My methodological views were – and I guess still are – pretty Austrian. In Ludwig von Mises’ “Human Action” the first sentence of Chapter one is “Human action is purposeful behaviour”. Mises and other Austrian school economists claim (I think more or less rightly) that all economic theory can be deducted from this dictum. That view kind of clashes with Friedman’s positivist thinking – that theory has to be empirically tested.

All in all, Friedman would probably have been happier about today’s Nobel Prizes in economics than I am (See my earlier post). That said, over time I have come to appreciate Friedman’s methodological views more and more and I no longer think that there is such a big conflict Friedman’s methodological views and the views of the Austrians. But yeah, I am pretty much like Friedman – you write one paper on methodology and then you forget about it. So maybe you might want to stop reading now.

However, in my paper on Market Monetarism I tried to find to common methodological views of blogging Market Monetarists. That said, you could have reached a Market Monetarist position coming from a deductive perspective (that is more or less how I have arrived here) or you could have come to your Market Monetarist views via econometric testing that tells you that Market Monetarism is empirically correct (the method Friedman recommend). So when I talk about methodology here it is clearly in a relatively broad sense.

Given that Market Monetarism as an economic school is very young and only really “live” in the blogosphere, it is difficult to discuss a methodological approach. However, there are some common attitudes to methodology among the Market Monetarists.

In particular, I highlight the following methodological commonalities.

1. Sceptical view of “large scale” macroeconomic models. The Market Monetarists tend to dislike the kind of large-scale macroeconomic – typical New Keynesian – models that, for example, most central banks utilise. Rather, Market Monetarists prefer simpler, smaller models and dictums.

2. “Story-telling” and a general case-by-case method of studying empirical facts rather than using econometric models. This is due to the Market Monetarists’ view of the monetary transmission mechanism as basically forward looking. Despite significant progress in econometric methods, common econometric methods basically cannot handle expectations and therefore any econometric study of “causality” is likely to be flawed, as monetary policy works with “long and variable leads”.

3. Market Monetarists’ preferred empirical method is to combine actual knowledge of relevant news about, for example, monetary policy initiatives with analysis of market reactions to such initiatives. As such, Market Monetarists’ methods are highly eclectic.

4. Market data is preferred to macroeconomic data. As markets are assumed to be efficient and forward looking, all available information is already reflected in market pricing, while macroeconomic data is basically historical and as such backward looking.

5. Economic reasoning rather than advanced maths. Market Monetarists base their thinking on rather stringent economic theorising and reasoning but are very critical of the kind of mathematically based models that dominate much of the teaching in economics these days.

That’s my two cents on Market Monetarist methodology, but don’t take it to serious – or at least that is what Deidre N. McCloskey would tell you. McClosky’s book “Knowledge and persuasion in economics” is that latest (of very few) book that I have read on Methodology. In it she tells us (page 32-33):

“Economists march to and fro under different banners, raising huzzahs for different candidates for the Nobel Prize. Party loyalty provides a career. The young upwardly mobile indoctrinated economist (YUMIE) always votes at his party’s call and never thinks of thinking for himself at all. Yet the existence of schools fits poorly with the receive theory of science. The theory most economists espouse says that “findings” will “falsity” the “observable hypothesis derived from higher order hypotheses” and then of course everyone will change his mind. But nobody changes his mind. The number of economists who have abandoned a hypothesis and have admitted so in public is close to zero. But that turns out to be true also of the Science that economists think they are emulating”.

I tell you, she writes like that all through the book! At the end you are slightly embarrassed to be an economist, but then after five minutes of putting down the book you are back to you all sectarian habits. BOOO! The Keynesians are clueless and so are the Austrians!

(BTW BUY that book it is damn good!)

3 Comments
by Lars Christensen on October 10, 2011  •  Permalink
Posted in Austrian economics, General economic theory, MM Research agenda, Reading recommendations

Posted by Lars Christensen on October 10, 2011

https://marketmonetarist.com/2011/10/10/market-monetarist-methodology-%e2%80%93-markets-rather-econometric-testing/

Why I Am Not an Austrian Economist

My post on Bob Murphy’s critique of Market Monetarism has triggered a slight discussion about Austrian economics.

I do not consider myself as an Austrian economist, but I certainly have been inspired by reading the Austrian classics over the years – particularly Ludwig von Mises’s “Human Action”. That said, in terms of the development of monetary theory I do not believe that the Austrians have much to offer.

When I talk about “Austrians” that do not include Free Banking theorists like George Selgin or Larry White. In fact I think that Market Monetarism and the Free Banking schools theoretically is very close. George do not consider himself to be Austrian, while I think Larry still says that he is Austrian inspired.

Some years ago Bryan Caplan wrote an excellent piece on why he is not an Austrian. While I do not agree with everything Bryan says about the Austrians (and Children!) I nonetheless think his paper is pretty much spot on in the critique of Austrian thinking. (I stole the headline for this post from Bryan…)

It should also be acknowledged that there is not one Austrian school, but a number of Austrian school – more or less dogmatic.

Enough discussion of Austrian dogma – back to Market Monetarism…

5 Comments
by Lars Christensen on October 8, 2011  •  Permalink
Posted in Austrian economics, Reading recommendations

Posted by Lars Christensen on October 8, 2011

https://marketmonetarist.com/2011/10/08/why-i-am-not-an-austrian-economist/

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