All posts in category General economic theory

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/

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/

Some (Un)pleasant Nobelmetrics…

Ok, I was wrong. I kind of expected that Scott Sumner would not get the Nobel Prize in economics (yeah, yeah I know that its not a real Nobel Prize…) and no I can hardly say that Thomas Sargent and Christopher Sims are not world class economists. Both certainly are, but I must say I am a bit disappointed by the increasing focus among economists on econometrics. But there is no reason to blame Sargent and Sims for that.

Sargent and Sims were awarded the Nobel Prize for“for their empirical research on cause and effect in the macroeconomy”

It might as well have said that they got the Nobel Prize in for developing the econometrics – particularly Vector AutoRegression (VAR). This is why I am slightly disappointed. Economics is not statistical method. To me, and his might make Bob Murphy happy, economics is mostly a deductive science or what Ludwig von Mises called Praxeology. That does not mean that we should not use math (as the Austrians are suggesting) or not test our theories empirically, but I find it highly problematic that economic reasoning has become less important for our profession than fancy statistically methods. I could of course also say as Nick Rowe usually say that we dislike econometrics because we are so bad at it, but frankly I have seen very few econometric results that have changed my mind on any particular issue.

From a Market Monetarist perspective there is reason to be sceptical about econometrics. Econometrics is about history – it basically by method assumes that expectations have no importance (yes, yes I know Sargent and Sims have tried to change that…). To Market Monetarists expectations about future monetary policy is key to how we understand monetary policy. Studying monetary policy in the rearview minor does not teach you anything. (I will later today put out a comment on Market Monetarist methodology as I see it…UPDATE: I JUST DID).

So do Sargent and Sims not deserve the Nobel Prize? Yes, let me say it again they certainly do deserve the Nobel Prize. It is well deserved. I am just unhappy that they get it for econometric work rather for economic thinking.

In fact Sargent have written a number of papers that I consider to be among the most import papers I have ever read.

In 1981 Sargent wrote the paper “Some Unpleasant Monetarist Arithmetic” with Neil Wallace. In my book that paper alone qualifies for a Nobel Prize. The story in their paper is pretty simple (a lot of good economics is). Sargent and Wallace tell us that public expenditure can be financed in three ways in the short-run: Taxes, borrowing (issuing bonds) and by printing money. In the long-run you have to pay back your debts so that will leave only two options – taxes and printing money. In a world with rational expectations – forward looking economic agents – this means that if a government is running large deficit then it will sooner or later lead to either higher taxes/lower expenditures or to higher inflation. And as agents are forward looking an unsustainable large budget deficit this could trigger a sharp rise in inflation already before the money printing starts. This is pretty Sumnerian: Monetary Policy works with long and variable LEADS. (Anybody who thinks the US will default should read this paper and look at US bond yields…).

A less well-known paper by Sargent (co-authored with Joseph Zeira in 2008) “Israel 1983: A Bout of Unpleasant Monetarist Arithmetic” is another of my other favourite economics papers. It is wonderfully written and very intriguing. Here is the abstract for you:

“From 1970 to 1985, Israel experienced high inflation. It rose in three jumps to new plateaus and eventually exceeded 400% per annum. This paper claims that anticipated monetary and fiscal effects of a massive government bailout of owners of fallen bank shares caused the last big jump in inflation that occurred in October 1983. Bank shares had just collapsed after a scandal in which it was revealed that banks had long manipulated their share prices. The government promised to reimburse innocent owners for the diminished value of their bank shares, but only after four or five years. The public believed that promise and public debt therefore implicitly increased by a large amount. That implied future monetary expansions. Because that was foreseen, inflation immediately rose as predicted by the unpleasant monetarist arithmetic of Sargent and Wallace (1981)”

So once again, I think Sargent and Sims deserve to win the Nobel Prize. They are world class economists, but I would so much have hope that they have gotten it for economics and not for statistical method.

Congratulation Thomas and Chris!

PS I am really just an angry Danish nationalist, if you want to award the Nobel Prize in economics to statisticians for their work on VAR why not give it to the best? My country man Søren Johansen and his wife Katarina Juselius. Maybe next year Søren and Katarina…ah sorry guys next year Scott Sumner will get it…

5 Comments
by Lars Christensen on October 10, 2011  •  Permalink
Posted in General economic theory, Reading recommendations

Posted by Lars Christensen on October 10, 2011

https://marketmonetarist.com/2011/10/10/some-unpleasant-nobelmetrics%e2%80%a6/

The big IS/LM debate – DeLong comes under heavy shelling

The IS/LM model is standard macro textbook stuff. Unfortunately the model is highly problematic and even worse it seems like the IS/LM model (in its most simple form) is the only model that certain policy makers understand. Recently a debate about the IS/LM model has been flaring up.

Tyler Cowen first explains what he thinks is wrong with the IS/LM model.

Then Keynesian blogger and economist Brad DeLong blogs in defense of the IS/LM model.

But DeLong comes under heavy shelling from the Market Monetarist camp:

Scott Sumner, Nick Rowe and David Glasner all weigh in on the debate.

You tell me who is winning the debate…

4 Comments
by Lars Christensen on October 8, 2011  •  Permalink
Posted in General economic theory, Reading recommendations

Posted by Lars Christensen on October 8, 2011

https://marketmonetarist.com/2011/10/08/the-big-islm-debate-delong-comes-under-heavy-shelling/

Newer Posts »