Recent economic data has convinced the Bank of England not to expand its Quantitative Easing program. According to the Office of National Statistics, annual CPI inflation rose from 3.3% in November to 3.7% in December, 2010 and is now currently 4%. The overall expectation is that CPI inflation will peak at 4.4% by the middle of 2011.
This increase in inflation coupled with poor economic data (with GDP contracting 0.5% last quarter) has come as something of a shock to the Bank of England. The Bank was apparently operating under the assumption that printing money was the way to get the economy going. They are surprised that the result has been a significant increase in inflation and a worsening economy.
Rather helpfully, on the Bank’s website there is an explanation of how Quantitative Easing was supposed to improve the economy. Quite clearly, the Bank explains that they purchased British Government bonds (gilts) and high quality (investment grade) bonds from private sector companies (banks, pension funds, insurance companies and non-financial institutions). The Bank’s concern was that there was too little money “circulating” in the economy. Using this method, the Bank was able to inject the much needed money directly into the economy and the companies that needed it. The idea was two-fold; a) asset prices increase, wealth increases and spending increases; b) more money, means more spending, bank reserves increase, meaning more lending, spending and income increases, inflation arrives at the magic 2% rate and we all live happily ever after, growing fat off of the magic wealth creation machine at the Bank. But there is a dark side to this fairy tale and at the risk of sounding clichéd, it is because in this case, more money really does mean more problems.
The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value. If this were true, none of us would need to work. The government could just issue us all with paper, ink and printing presses. Whenever we needed to buy something we could just print off some money and go to the shops and buy what we need. And of course, prices would rise, the shops would make lots of profits and apparent wealth would increase. There is one nagging doubt however. Who would make all the goods that we would buy, if we are all sitting at home printing money? Perhaps we could get the Morlocks to do it. Or maybe specially trained chimps.
Clearly, the Wizards of Oz, currently residing at the Bank of England, do not understand how value is created, how capital grows and how the wealth in society is generated. To create value one must produce something of value, a good that someone can use to improve their wellbeing or allow them to subsist. This good can be sold for money and the money can be used for consumption, held as a cash balance or to improve the tools needed to produce a greater quantity and quality of goods. Ultimately, all money will be spent on either a consumer good (like a loaf of bread or a new pair of shoes) or a capital good (like a baker’s oven or shoe-making machinery). The latter choice would result in an increase in capital (the value of all capital goods) and capital goods, and in the long run, a general increase in wealth. The increase in wealth occurs because an improvement in the quality and quantity of capital goods allows us to create a greater number of better quality consumer goods in a shorter period of time. This increase in the supply of consumer goods means that their price will fall resulting in a reduction in the cost of living for the society at large. We will all be better off. The important concept to take away is that for this increase in wealth to occur, somebody had to sacrifice some of their consumption to instead purchase a capital good (otherwise known as an income producing asset). This increases the price of income producing assets relative to consumer goods. From the perspective of a consumer like you and me, the goods we buy become cheaper and in a healthy economy, the prices of consumer goods fall over time.
The Bank of England does not believe that any sacrifice is needed today for an increase in wealth tomorrow. In the Land of Oz you do not need to sell something of value in order to get money in exchange, you can just print money instead. Obviously, printing up banknotes does not create anything of value. What happens instead is the reverse of the process described above. The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power, meaning that the relative prices of consumer goods will rise over time. This will increase the cost of living for people in general, meaning their real wages will fall. Because the cost of labour is now comparatively cheaper, rather than invest in an increase in capital goods, companies will invest in labour instead (Jesus Huerta De Soto, 2009). This means there will be a lower quantity and quality of capital goods and a reduction in the future supply of consumer goods. For the average person, this means a lower salary and a smaller selection of more expensive goods to spend it on. Most of us become poorer.
But not all of us will become poorer. By printing this money and handing it over to a favoured few in society (i.e. the banks) this is in one sense, handing them nothing and in another sense, pure and simple counterfeiting. This is because, in the case of Quantitative Easing, the banks will trade this money for real or financial assets, or to their employees in exchange for their services. This increased monetary demand for financial assets or banking services will bid up their prices. The assets can then be sold in the near term at a profit and the banking employees will spend their increased salaries and bonuses on consumer goods before prices start to rise. Bankers will certainly feel wealthier. In fact, this whole process represents a wealth transfer from one group of people in society to the banks and a shadow tax on much of the population. This is because the early recipients of the new money (the bankers and the Government) will get to spend this money before the prices rise significantly. Slowly this new money will be dispersed around the economy but the further you are from the source the less it will be worth when you finally receive it.
The main beneficiaries of Quantitative Easing therefore, are the Government and the banks. The banks buy gilts from the Government and then sell them to the Bank of England (just under £200bn’s worth) at a profit. The Bank of England pays for these gilts with freshly printed money. Thus the Government has a ready buyer for its debt and the banks become more profitable and apparently more stable. Because of their now greater reserves and new found stability, the official rationale behind Quantitative Easing was that banks would then lend out these reserves to businesses and households thus stimulating the economy. Except, in fact the opposite has occurred. The economy has contracted, inflation is continuing to rise, net lending is down and unemployment has risen.
With a firm understanding of the basics of how wealth is created the Bank of England would have known this would happen. Unfortunately, they operate under the Keynesian delusion of how the world works and their main objective would appear to be saving the banks (because we are all doomed without them) rather saving the economy. With inflation getting higher and higher one might wonder why Mervyn King, the Governor of the Bank of England, does not simply raise interest rates or resell the gilts. However, this would set the Bank of England’s plan into reverse, with higher rates leading to lower asset values, weakened balance sheets and an increase in mortgage defaults, leading to more bank losses and bankruptcies.
Clearly, the Bank of England’s plan is doomed to failure and has been from the start. Mervyn King would have greater luck trying to empty the ocean with a bucket. The problem is two-fold; a) the Bank of England views the recovery or liquidation stage of the business cycle as a problem to be solved and; b) it tries to solve this problem by doing more of what caused this problem in the first place. This “solution” has prevented the necessary liquidation of unprofitable projects and write-offs of bad loans, and has continued to subsidise inefficient operations. Quantitative Easing has resulted in a transfer of wealth from society at large to the banks and the Government, and has vastly extended the length of what would have been a short but sharp recession. Quantitative Easing has made us poorer while benefiting a select few in society.
This is a crime by any measure.
The Bank of England would not disagree with you about how wealth is created. They are not foolish enough to believe that they can create wealth by printing money.
And, they aren’t Keynesians, most of the board are various types of Monetarist.
I didn’t say they were Keynesians. In my view (and that of Rothbard) Monetarists are not much different to Keynesians however. Sure there are some differences but they are both essentially Statists. Two sides of the same coin if you will. Hence, I say they operate under the Keynesian delusion.
I am judging the BoE by its actions and its words. There is a pamphlet (to which I referred in my article) that you can download from the BoE websites which specifically states that QE will increase wealth. If they are not so foolish as to believe what they say and do… that only leaves malicious intent.
“They are not foolish enough to believe that they can create wealth by printing money.
And, they aren’t Keynesians, most of the board are various types of Monetarist”.
Perhaps so, but these factors do not alter the substance of the fact that…
“With a firm understanding of the basics of how wealth is created the Bank of England would have known this would happen”.
thus making your notion that..
“The Bank of England would not disagree with you about how wealth is created”
a debatable one at best – or at least, so it seems to me.
Mr Sadler writes perfect sense. The only long term solution is a painful re-adjustment, where the most over-exposed reap what they have sown. There are two realities of life to consider. First, the political will to guide this adjustment is not there. If you consider the UK coalition to be a starting point for this adjustment then you must ask whether they have the staying power necessary? Is our political system able to cater for the required stamina? Second, life is not fair. Democracy is only the best of all the worst possible solutions (apologies to Churchill). Doing ‘the right thing’ will entail too much pain for the majority. How do we move forward?
1. I agree that QE is a daft policy. But that is because it is very distortionary. It involves boosting an economy via what Robert Saddler calls the “favoured few” (banks, the rich, etc).
The idea that QE equals money printing, pound for pound, is an over simplification. QE simply involves swapping one form of government / central bank liability (monetary base) for another (gilts). Indeed government bonds are widely accepted in the World’s financial centres as the equivalent of money.
What DOES equal money printing is quantitatively easing the bonds created by a government “borrow and spend” policy. Borrow and spend involves, 1, govt borrows £X, 2, govt spends £X, 3, govt gives bonds to those it has borrowed from. Net result: private sector is up to the tune of £X worth of bonds. If those bonds are quantitatively eased, then the whole operation equals money printing.
But the question as to whether QE or “borrow and spend” has the main stimulatory (and possibly inflationary) effect is extremely complicated.
2. It is not true to say that in respect of QE that “the result has been a significant increase in inflation.”
The so called inflation currently afflicting us is mainly the result of the 2008 devaluation and world commodity price increases. If QE were the cause of inflation you’d expect to see excessive demand coming from native British consumers. I don’t see that.
3. The idea that the BoE is under the illusion that a country can grow rich simply by issuing bits of paper with “£20” printed on them is absurd.
4. We all owe a big debt to Robert Sadler for explaining that wealth requires the production of goods and services and investing in capital equipment. I won’t be recommending him for a Nobel Prize in Economics for that non-insight.
5. Robert Saddler claims that “The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power, meaning that the relative prices of consumer goods will rise over time.” So how come the U.S. monetary base expanded by an astronomic and unprecedented amount around two years ago, yet so far inflation is nowhere to be seen? And the U.S. government bond market is not currently factoring future rampant inflation into its calculations.
6. I agree with Robert Sadler that when government DOES create new money it should not be handed to what he calls the “favoured few”. Thomas Edison (the inventor) made this point.
I have described QE according to how the BoE details it on their website.
I am defining inflation as an increase in the fiat money supply. Your definition of inflation appears to be circular. I am not sure what you mean by British excessive demand.
This is the reductio ad absurdum of QE.
I believe the term is ceteris paribus.
This is not my position. I don’t think Government should create new money at all.
If you read the speeches of Bank staff then it’s pretty obvious that the Bank’s rationale for QE was that it wanted to prevent a large contraction in the money supply and that it wanted to reduce the cost of corporate funding.
Of course there are many meanings of “wealth”, depending on context. When the BoE talks about QE increasing wealth, it means that individual asset holders will see the value of their assets rise, and might adjust their spending patterns accordingly, not that Zimbabwe is on a fast track to becoming Switzerland anytime soon.
This statement, for example, is flat-out false:
“The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value. “
The idea that the Bank expects that QE will make the country wealthy in the sense of being more productive is, yes, a bit silly—a straw man, in fact. If they do, why limit QE to just one point in time? Why not expand the programme? A QE for every borough in the land! A QE for all time! The fact that they don’t do this all the time is pretty good evidence of the fact that they don’t think like this at all, in my opinion.
As to inflation, at constant tax, inflation is basically looking how we want it to look. You can factor in the fall in the pound and King looks like he’s doing his job pretty damn well to me. “Crime of QE”—I mean, really.
Finally, I thought it was a bit strange that you criticized Ralph for circularity before giving your own circular definition of inflation. I agree that if inflation is defined as an increase in the money supply, then increasing the money supply causes inflation.
Thank you for your comments.
What I read was the Bank’s own description of what it was trying to achieve. It explicitly states that one of its objectives among the others you mention was to increase total wealth.
I agree that another objective was to reduce the cost of lending (to consumers as well as corporations). They failed to achieve this objective. Not surprising given the fallacious reasoning behind their approach. Trying to prevent the deflation in the money supply was a fool’s errand since this is exactly what needs to occur in the liquidation stage of the business cycle.
I am assuming the economic definition of wealth. I also assume the BoE does the same.
It is quite obvious from the BoE literature freely available on their website that this is the operative assumption. They state over and over that increased asset prices facilitated by electronically “printed” money will lead to an increase in total wealth and the other effects you mentioned.
That’s a neat restatement of the reductio ad absurdum argument I used in my article. Yes it is silly, but I can only go by the words and actions of the BoE. As for what they want, expect or think, I can only guess.
I guess you and I have different ideas of what a good job is. So far, King appears to have completely failed to meet every objective he set for himself. So much for inflation at 2%.
For me, a crime is taking something from someone else without their consent. This is precisely the result of the BoE’s engineered inflation.
The increase of the money supply (i.e. inflation) is caused by the activities of fractional reserve banks and modern central banks.
Can you link to the “Bank’s own description of what it was trying to achieve”? I suspect you mean the short pamphlet the Bank produced explaining QE to the (lay, non-economist) public, as opposed to any number of the speeches and papers it prepared for expert audiences, but it’s not easy to respond without knowing for sure.
“They failed to achieve this objective.”
No idea how you know this with any certainty. The cost of corporate funding certainly fell after QE; now, there’s probably more to it than post hoc ergo propter hoc, but it seems reasonable to assume that there is at least some connection between the two phenomena.
“Trying to prevent the deflation in the money supply was a fool’s errand since this is exactly what needs to occur in the liquidation stage of the business cycle.”
That’s a matter of opinion. But preventing deflation is what the bank has tried to achieve—so that it could hit its inflation target in the long-run. If you read the latest inflation report, the Bank thinks that inflation will be above target for the rest of this year because of VAT, energy and import price rises, but that these will fade going forward, so that the chances of being above or below target are roughly evens.
“For me, a crime is taking something from someone else without their consent. This is precisely the result of the BoE’s engineered inflation.”
The Bank hasn’t really engineered inflation above its target though, has it. If you subtract out the energy price rises and the VAT rise, then (CPI) inflation is pretty flat through 2010.
Let’s turn this around a bit. If the Bank prevented inflation over and above its target, would that be a crime? What about the equivalent case where it prevents disinflation or deflation?
“The increase of the money supply (i.e. inflation) is caused by the activities of fractional reserve banks and modern central banks.”
Well, yes. The money supply is determined by supply and demand for money. More interesting to me is, what is M4 doing and what is the price level (however defined) doing.
Here are some data on M4: http://www.bankofengland.co.uk/statistics/m4/2010/sep/M4SA.GIF
NB: note that we are in a two-year disinflationary period according to your definition of inflation.
And inflation as measured by the CPI: http://www.statistics.gov.uk/pdfdir/cpi0211.pdf
Something to note is the reductio ad absurdum isn’t always a good tool for economic analysis.
In several books academics have argued for the Labour Theory of Value by using a so called “Corn Economy” where the only tradable good is corn. In that economy there can be corn for consumption and corn for production, but that’s all. In such an economy the labour theory of value is very close to being true because there are so few marginal decisions.
The same sort of thing is true about quantitative easing. One can easily state that a supply of money greater than the excess demand for money will be damaging, that’s true. The important question is what about satisfying the excess demand for money? and what about at least coming closer to satisfying it?
I explained some of the issues here
What concerns Central Bankers and other Monetary Economists isn’t the long run creation of wealth, it’s that short-run monetary disturbances may be destructive.
A common view these days is that there is a trend in money-prices that people expect. If prices fall below trend then that doesn’t just change prices, it results in a recession too. That is because prices take time to change. In the interim before they have changed output falls. I generally agree with this view, with some tweaks I won’t go into now.
As Ralph Musgrave points out the quantity theory of money isn’t correct in the short run. Robert Sadler writes: “The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power”. That’s true, but only in the long run when the dust has settled. As a matter of historical fact output prices have not followed the monetary base closely in many past recessions. We shouldn’t expect them too either because we shouldn’t expect the demand for money to be constant.
Thanks for the link, I’ll take another look at your article.
With respect, I think you may have taken my comment on the purchasing power of money slightly out of context. I did say “over time”. That aside, of course we are now seeing quite clearly the impact of the BoE’s inflationary activities even before the dust has settled. Even so, I would say that it is likely demand for money has increased lately and this has reduced the impact of monetary inflation.
I didn’t notice that you said “over time”.
What I’m trying to say here is that I think the Bank of England were quite right to increase the quantity of money during the recession. Doing so helped offset the increased demand for holding it.
Whether or not they got the quantities involved right, I believe they were right in principle. What I would criticise them (and the Fed) most for is not being clear about their future policy. This caused a great deal of uncertainty. If they hadn’t caused that uncertainty the fall in output that spurred quantative easing may not have arisen.
I thought you were a free-banker or that free-bankers opposed central banking. Have I misunderstood you?
That said, I agree that there was an increased demand for money – why did the BoE need to offset it?
Yes, I’m opposed to Central Banking. But, in the imperfect world that we have where Central Banking exists in this case it was a reasonable policy.
No Central Banking would be preferable, but given that we can’t have that some expansion is better than none.
The BoE could have kept the quantity of money constant and allowed prices to fall. Doing that though would have caused a recession. Because prices take substantial time to fall spending will fall faster than prices. The consequence of this is that output will fall further. What Steve Horwitz calls “Wicksellian Cumulative Rot”.
Robert Sadlers explanation is without doubt the most compelling, although I doubt very much that the Bank were simply unable to understand the crime they were about to commit when first they embarked on their money printing exercise
Those who point to the relatively low level of “general” inflation we are expriencing are blinded by the text book definition of inflation.
An increase in the supply of money these days will not necessarily lead to a general increase in prices particularly whilst we are being supplied with cheap produce by the likes of China and India which help to contain wage push inflationary settlements.
The increase in the money supply can result in a more focused increase in specific asset values as the recipients look to invest their new found wealth and this can of course result in, amongst other things, commodity prices to rise.
There is little doubt in my mind that the money printing we have seen so far will ultimately manifest itself in the general devaluation of the money in the system and that the great losers once again will be the poor.
The Bank of course knew this from the start when they decided the victims would be those too weak to fight back.
Yet this is indeed a crime of mammoth proportions committed by criminals who did indeed know that their actions would be felt the hardest by the poor, but who will find that the unintended consequence of their actions in pushing up commodity prices will be far more devastating than even they might have conceived.
You can think whatever you want about the motives of the Bank of England, or of me for that matter. It doesn’t much help debate though. Let’s concentrate on the actual issues of monetary policy for a while…
You’re quite right that the textbook definition of inflation is troublesome. CPI inflation leaves out everything that’s not a consumer good produced in the current period. Wider measures like the GDP deflator only consider current period output and omit intermediate goods too. A proper measure of price inflation would consider *all* goods and services including goods produced in previous periods and including intermediate goods.
You’re also quite right that price inflation is never even. The processes by which it occurs makes it unlikely that all goods will rise in price in a uniform manner.
I agree too that this spike of inflation will harm holders of money. But, I think this is because the BoE have gone too far. They have not withdrawn the extra money they injected quickly enough.
They where quite right to create money at the beginning of the recession though. That helped prevent further recession caused by sticky prices interacting with rising money demand. If they hadn’t done that then the rise in demand for money would have caused a fall in demand for goods. Goods producers wouldn’t have simply interpreted this as a need to lower prices, they would interpret it as a need to cut-back production. When they did that the recession would deepen.
“They where quite right to create money at the beginning of the recession though. That helped prevent further recession caused by sticky prices interacting with rising money demand. If they hadn’t done that then the rise in demand for money would have caused a fall in demand for goods. Goods producers wouldn’t have simply interpreted this as a need to lower prices, they would interpret it as a need to cut-back production. When they did that the recession would deepen.“
I have to say Current I am a bit perplexed by your view here. In previous threads you have said that whilst you are a supporter of fractional reserve banking you are opposed to central banking. How do you reconcile this position with the statement above where you seem to be advocating active central bank intervention to steer the economy away from recession?
Also, why would producers interpret a fall in demand as a need to cut back production rather than lower price? You may well be right, but I would be interested to understand why you think that is the case. I am sure a Rothbardian would answer that the only reason for this behavior is that inflationary expectations are built into the system (and therefore into people’s psychology). In their view, if we had a fixed quantity of money, people would adjust (maybe painfully in the short term) to deflationary expectations and they would therefore interpret a reduction in demand for their goods differently (ie. a need to reduce prices) because they would be conditioned to expecting that their prices would reduce over time. In other words, it is the incessant tinkering with the money supply by the central bank that causes the very behaviors that then require further central bank tinkering.
Central bank intervention is everywhere and nowhere. Even if the central bank do “nothing” they are still intervening because they are holding the commercial banks to the regulations set for them. If the commercial banks were free banks then in a situation like that in 2009 they would have created new money. But, in the situation we have they can’t do that without central bank action.
Like other advocates of Fractional Reserve Free Banking I think that monetary disequilbrium theory provides the right theory for understanding the business cycle. If we had FRFB then that would compensate for monetary disquilibrium and provide growth with far fewer recessions than current policies. But, since we don’t have that the second best option is to get the central bank to compensate for monetary disequilibrium.
Well, empirically this has been shown to happen.
Think about the situation a producer faces. If a fall in demand isn’t expected for some reason then the entrepreneur must ask why it’s happening. The entrepreneur could cut prices but when doing this there is always a trade-off between profit and volume.
Let’s suppose I sell 100 widgets per week at a price of £10 per widget. My cost per widget is £3 and my fixed costs are £500. I therefore take £1000 and spend £500+100*3 = £800, so my profit is £200. Suppose then that demand falls to 90 widgets per week. I then make £130 profit (£900 – £500 – $270). If I reduce my prices then I can regain my normal output level though not my normal profit. What though is the profit maximizing thing to do? The answer is it’s only profitable for me to raise output under certain circumstances.
Specifically, under these assumptions:
V = volume, that is number of widgets sold
P = price
P = 3 + 630/V
So, to make it worth my while expanding output to 100 units I must be able to obtain those sales with a price greater than £9.30 per unit. If it would take a lower price to bring out 100 buyers again, then it’s not worth it for me. If I had more fixed costs and fewer variable ones the breakpoint would be at a lower price.
This, of course, applies until the suppliers and workers have time to change their prices.
The same sort of thing applies to rising prices of-course too.
That’s true too. One of the problems with the current setup is the pain that would be caused by moving to a different long-run price path. A deflationary path would be better, but getting there is troublesome.
That’s pretty much true. The problem though is that the 100% reserve system wouldn’t produce steady deflation. In the short-run the price level would be determined by the demand for money. If the demand for money falls then it would rise, and if the demand for money rises then it would fall.
Let’s suppose that people are accustomed to prices that fall gradually in the long run. That still doesn’t mean that a rise in demand for money is harmless. It would cause an *unexpected* fall in spending. Which would still cause a fall in output as well as prices. The forces I mention elsewhere in this thread would still come into action.
In the end there is only one thing that can cause a sustained general rise in prices, namely, a change in the ratio of money to goods and services available. This, in turn, can be generated in two ways: first a sustained increase in the supply of money; or second a sustained increasing scarcity of a fundamental input resource (ie. oil) which leads to increased scarcity of almost everything else and therefore a general increase in prices. In my opinion it is the second issue that should be concerning us much more than the first. After all, the impact of QE on money creation can be stopped in its tracks overnight by introducing legal reserve requirements on the banks (as the Federal Reserve has said it may do in the US at some point). It is far more difficult however to increase oil production overnight: indeed, oil production has hardly changed in the last six years at around 85mbpd and prices are now spiking again as demand grows but supply remains stagnant. This, in turn, is feeding into increased prices of all other commodities (including food), products and services. In these circumstances, the only way to reduce inflation is to reduce the supply of money – but that doesn’t actually help to eliminate the fundamental scarcity: it just means that the money supply shrinks as the economy shrinks in response to the increasing scarcity. No wonder the BOE is floundering, they simply cannot understand what is happening because peak oil is not built into their mental models monetarist or Keynesian).
Perhaps it’s easiest to give a simple microeconomic example.
Let’s suppose that we have a shop which serves 10000 customers per month. For some reason that isn’t directly relevant here the economic outlook becomes more uncertain. As a result many of the regular customers decide to hold more money and spend less. Some of those customers decide to make their cut-backs in goods bought at the shop we’re considering.
That means that in the very short-run takings in the shop will fall. Now, does that fall mean that prices will fall? Yes, but not straight away, in the interim less sales will be made. Initially the shop’s manager will probably decrease prices out of his own margins in order to maintain a reasonable trading volume. Many other shops similar to the one we’re considering will do the same. Then the wholesalers that sell to those shops will see their sales falling. They will in-turn reduce their prices. This process will then continue on through the economy. At each stage there will be a reduction in prices, but there will also be a fall in output because of the time prices take to change. Of course some of these changes may be expected and some businesses may make price changes in anticipation of future events.
If this deflation isn’t expected then during this time there is account falsification in the reverse direction to that normally considered. Accounts will understate profits, that is, the real value of profits will be larger than expected. Suppose for example that due to falling sales and prices our shop owner’s profits are reduced by 10% compared to the previous year. If in that year there is 5% deflation, a rise in the value of money by 5% then in real terms his profits have not fallen as much as he thinks.
In this situation the banking system can help by creating new money. In the simplest case the money a bank creates is a loan to that bank. The bank can then lend money to entrepreneurs. It can’t directly supply money to the customers of the shop who decided to reduce their spending and relieve the problem at the local level. The entrepreneurs that the banks lend to can then spend money elsewhere preventing the price level from falling and preventing account falsification.
This is all really an aspect of saving. When people hold money they are saving, money is a form of savings certificate. A rise in demand for money is a rise in demand for those savings certificates. The banks can accomodate that rise if they can find matching investments.
Current, thank you for that clear concise explanation of your position.
However, I feel that you have only looked at one side of the equation. For example, don’t falling consumer prices mean rising real wages? In this case, would this not prompt businesses to cut back on labour and increase investment in capital thus improving productivity in the long run and increasing profits levels back to the “normal” level? In this case, the workers who lose jobs in the consumer sector will now find jobs in the comparatively more profitable capital goods sector; granted, at a lower nominal wage. Furthermore, won’t the rising real wages make the workers better off?
Secondly, wouldn’t having the banks create more money actually frustrate the objectives of the consumers who will see the purchasing power of their money fall? In this case, aren’t the banks actually violating the property rights of the money holding consumers?
Thirdly, if we agree that creating money doesn’t create value, how can giving an entrepreneur something of no intrinsic value benefit anyone?
Lastly, it seems to me, that your definition of deflation slightly contradicts your definition of inflation. Would you mind clarifying both? I would point out that the Rothbardian definition of deflation is different to what you have described. Falling prices, according to Rothbard, are not deflation per se.
When we’re discussing this sort of thing we’re mostly concerned about unexpected short-run changes. Let’s suppose that normally prices of consumer goods fall by 2% year-on-year. In that case any consumer serving business will know that normally he must reduce his prices. Of course, all the concerns of the particular market he is in will probably be more important. But, nevertheless, he will be aware of the general trend. The same is true for his suppliers, employees and his shareholders. So, if an employee sees no change in his wage per year he will estimate that it has increased in real terms by 2%.
With a recession though the situation isn’t always like that. If there is an increased demand for money then people can’t easily expect the consequences that follow. That means as spending falls businesses see this as a fluctuation in demand, not as a an anticipated change in the purchasing power of money.
If this situation continues then the “Pigou Effect” comes into effect. Wage earners recognise that they are being paid more in real terms. But, that can’t happen in the short run. People only realise that they were earning more in real terms after the event. When that happens it aides recovery for the reasons you state, but in the interim output and employment will fall.
The idea of a monetary-disequilibrium policy is that changes in the stock of money are used to counteract changes in it’s purchasing power caused by fluctuations in demand for it. The idea is to stabilise the purchasing power, and in the case we’re considering here of a recession to prevent it from rising.
I don’t think so. The whole issue of the morality of Fractional-reserve banking is really something separate, which I’ve commented on here many times.
This was what I set out to tackle in my article “Money is barren, but occasionally covers us with dust”. The “barrenness” of money is a long-run property. It doesn’t mean that money is non-neutral in the short-run. Creation of money, and in other cases destruction of it too, can prevent destruction of wealth. And, when monetary policy is bad both can cause destruction of wealth. Of course neither can create wealth.
Normally I use the modern definitions of deflation and inflation, that is falling and rising prices; price deflation and price inflation. I know that Rothbard (and Mises in his later books) use deflation and inflation to refer to creation and destruction of money, monetary deflation and inflation. I don’t normally use it that way, I just speak about creation or destruction of money.
I don’t think I’ve been inconsistent. In my reply to waramess above I was pointing out the weaknesses of various measures of price inflation. I was pointing out that price inflation involves all prices, not just consumer prices and not just output prices. Lots of people seem to have forgotten that when they’re using the GDP deflator or CPI they are estimating overall price inflation from a measure of a small set of all prices.
I’ll come to your longer post later but just on the following:
Reductio ad absurdum; isn’t logic universal? Therefore, it can be applied to any argument, economic or otherwise? I mean if the logic of the argument is that creating a small amount of money creates value in one circumstance then this should hold true in all circumstances. i.e. If it is true that printing cash and buying bonds is good for the economy when the BoE does it, should it not also be true that if everyone prints money and buys bonds (or any other good) it will be good for the economy? Obviously that is absurd. So why believe it in one case and not the other?
Excess demand for money; there is no need for extra “money”. Holding the supply for money constant, if the demand for money increases, the purchasing power of money increases and in general prices decrease. This satisfies the “excess” demand for money. Any supply of money is optimal. More money does not create more value. Value (i.e. a produced and marketable good) is traded indirectly via “money” to purchase another good.
Whether it applies or not depends on the exact problem.
Let’s take another economic problem. Suppose that I am Robinson Crusoe and I have six bags of corn. Suppose that I put higher value on corn milled into flour than I do on corn in it’s raw state. So, if I apply my labour to some of the corn I have and grind it into flour then I obtain more utility.
Does it follow that if I mill *any amount of corn* into flour that I obtain more utility for myself? No, it doesn’t. That’s because no argument has been presented that a indicates that the conversion is “scalable”, and it isn’t. The same applies to money.
Notice also that I haven’t argued that creating money creates wealth, I’ve argued that creating money can prevent the destruction of wealth.
All this is true in the long term, but not in the short term. Prices cannot move instantaneously, so there will be a fall in output until they do. I’ve explained the reasons for that already in this thread.
I agree with the last two sentences here, these are the classical doctrine of the “barrenness of money”, which I explained recently in an article here.
But, I certainly don’t agree with your first statement: “Any supply of money is optimal.” As I explained in that article the barrenness of money is a long-term theory it depends on comparing two economies that are conceptually separate. It doesn’t really contain any clear ideas about the effect of changes in the stock of money. It is a quasi-static theory not a dynamic theory.
Going back to the sawdust analogy I made in my article, I think you’re pointing to two situations where the dust has settled and using them to argue that the dust isn’t a problem. (I’m paraphrasing Garrison here).
I understand what you mean. I would point out however, that the recession and the prior boom are symptoms of the distortion caused by the earlier monetary inflation. I accept that as employees are accustomed to rising wages (creating the money illusion of great cash-flow and wealth) if their wages do not increase automatically year to year there will be a period of adjustment. However, this is the economy correcting from the prior distortion and it is unavoidable.
I would venture that output and employment will initially fall but would correct itself much more rapidly than we have seen recently (i.e. going on four years now) if a new bout of monetary inflation is not commenced by banks, central or otherwise.
The purchasing power of money will naturally be stable without the manipulations of government or its agents. It is these monetary manipulations that cause purchasing power volatility. Left to their own devices, it is unlikely that the population would make drastic changes in their preferences for cash balances versus consumer good purchases.
Fine, we know where we both stand there.
And on to your next reply
Good point. However, I think we are talking about two slightly different things here. But I think we can expand your argument to illustrate further what I am talking about. First of all, Crusoe here is creating value by milling the corn into flour. Sure, the more he mills the less it is worth. After a while he mills more than he can consume himself. Let’s say he mills six sacks of flour and consumes four. His saving is two sacks. He notices that Friday has a nice spear that Crusoe would like for himself. He could use it to catch fish.
Unfortunately Friday wants four sacks of flour for the spear. Crusoe is two sacks short. However, Mervyn King happens to be walking down the beach and he sees the problem. Luckily for Crusoe, King has a solution. He takes Crusoe aside, out of sight of Friday and explains that all Crusoe needs to do is just fill up two sacks of sand and label them flour. Crusoe is excited and does exactly this. He hands over four sacks of “flour” to Friday and walks away with a shiny new spear. Crusoe is happy and King nods to himself sagely, a job well done. And for the time being, Friday is really happy as well…
But wouldn’t this have the same effect? Transferring wealth from one group in society to cover the losses of another? Against their will?
I am not sure that Garrison’s analogy really fits Austrian business cycle theory but I understand your point.
Thank you for providing those links. They were very helpful and I will respond to them below.
Yes the pamphlet was one of them.
I have seen mixed reports on the cost of corporate funding regarding whether the cost of borrowing has been reduced by the BoE. Really it seems to depend on who you are. In any case, the reducing the cost of corporate funding was only one of several objectives which generally do not appear to have been achieved.
I would say it is a matter of theory. Theoretically, according to Austrian economics (Rothbard et al), in the liquidation stage of the business cycle banks will seek to deflate by calling in loans, redeeming term loans and reducing new lending. This is also my personal experience. This is necessary to reduce the risk of the bank. Risk reduction is perfectly rational in a recession. The BoE is actually short-circuiting this process thus prolonging the recession.
I note the CPI report you linked indicates that prices rose 0.4 during 2011 when indirect taxes are excluded. However, the BoE itself states that its 2% inflation target is based on CPI not CPIY. Furthermore, the BoE surely could have anticipated the rise in VAT and oil and factored this into its policy. Thus not achieving its own target of 2% CPI must be regarded as a failure.
But let’s not forget. The overall purpose of QE and the other BoE manipulations was to stimulate the economy. After four years of recession this still hasn’t happened. I would also suggest that the full impact of the QE has not yet occurred since it will take time for this new money to circulate around the economy. Asset prices have risen as expected (see report above) but it is after profit taking etc. that we will see increased consumer purchases (and subsequent price rises).
The crime is that central bank engineered inflation, and in particular QE, represents a hidden tax on individuals with the primary beneficiary being the Government. This is true at any level of inflation. If we assume for sake of argument that a transparent tax is perfectly ethical then the inflation tax is unethical because it is conducted without the consent or knowledge of most of the population.
And in this case, I mean monetary inflation.
Simply put, the BoE should not be meddling in the money supply at all. The supply of money will be more efficiently provided by the free market. With well-defined property rights and free market hard money, banking crises and the business cycle will generally not occur.
I agree. And the reduction in M4 is what we would expect in an environment of banks reducing net lending. However, I think what we would see, in the absence of QE is deflation rather disinflation (according to my definition).
Thanks for the links. I think that they support my argument. Nowhere do they say that QE or standard monetary operations increase the productive capacity of the economy as a matter of course. It would be quite a bizarre innovation if they did, because it’s certainly not a piece of standard theory. As current has explained, the Bank’s objective were defensive: it sought to prevent something bad from happening, and/or to reduce the effect of the bad things that it didn’t prevent.
Now, you may think that it shouldn’t be doing any of these things anyway, but they are not the same as confusing the printing of money with producing more capital or increases in TFP.
When the Bank states, in the pamphlet “Quantitative Easing Explained”, that its asset purchase programme will raise “total wealth”, it simply means that QE will raise asset prices (lower rates), which is just basic supply and demand (plus some liquidity theory) and not controversial. Those of us holding these financial assets or their near equivalents are now “wealthier”, because their market value is greater. Of course society as a whole is no wealthier—the first order effect is purely nominal. I mean, presumably you agree that the Bank can at least cause a bit of asset price inflation…?
The Bank explains QE in its SMF manual:
“The Bank purchases these assets predominantly from non-banks… The Bank pays for the assets purchased by creating central bank reserves and crediting the accounts of the banks that act as intermediaries. Those banks will in turn credit the accounts of the non-banks from whom they obtained the assets. They will either spend the money on goods and services, which directly adds to overall spending, or purchase other assets, which will tend to boost the prices, and hence lower the yields, of those assets more broadly.”
Thank you for your reply
I agree with you. However, it was not my argument that the BoE thinks that it is directly increasing the productive capacity of the economy. Rather, that they state, that they are increasing wealth by engaging in QE.
It sounds like a bit of a contradiction to say its asset purchase programme will raise “total wealth”… yet society as a whole is no wealthier. That aside, as I explained in my article, QE represents a wealth transfer from one group in society to another with lots of economic distortion and waste in between. Society as a whole will actually be relatively poorer.
I actually think the BoE should be abolished but that is a discussion for another day.
“It was not my argument that the BoE thinks that it is directly increasing the productive capacity of the economy. Rather, that they state, that they are increasing wealth by engaging in QE.”
They are increasing “wealth”, if by wealth you mean the market value of a stock of financial assets, which is the sense in which the Bank uses “wealth” and “total wealth” in their short pamphlet on QE. The Bank is not increasing wealth if by wealth you mean, say, the PDV of future output flows, which is the sense in which you use it in the OP and comments section here.
As such I’m a bit mystified by your comment, “it was not my argument…” Surely that was your argument in its entirety.
“It sounds like a bit of a contradiction”
Is it really so hard to understand that the same word can take on different meanings in different contexts? I submit that, for those of us fortunate enough to not be robots, Mentats, or the descendents of Dr Spock, it is not hard at all. It seems like your whole article hinges on this misreading of one tiny part (literally one word!) of the Bank’s published output on QE.
One other thing that I find interesting is the fact that you have conceptually separated inflation and deflation. Both (unanticipated) inflation and deflation clearly represent redistributions of wealth. So why is inflation bad and deflation good?
Returning to some of your other comments,
“ I would say it is a matter of theory.”
It’s certainly a matter of theory, but which theory is the correct theory to apply is a matter of judgement, i.e. opinion—alas. Given the models the MPC use and their readings of the data, QE was correct policy. Other CBs pursued similarly unorthodox CB balance sheet operations—they rely on the same theory, saw the same dangers and responded with the same tools.
“I note the CPI report you linked indicates that prices rose 0.4 during 2011 when indirect taxes are excluded. However, the BoE itself states that its 2% inflation target is based on CPI not CPIY. Furthermore, the BoE surely could have anticipated the rise in VAT and oil and factored this into its policy. Thus not achieving its own target of 2% CPI must be regarded as a failure.”
Remember what the CPI is: it’s just the average price movement of all the price movements in its sub-indices, which represent categories of goods in a basket bought by a hypothetical consumer meant to represent the reference population. Unanticipated or not, a one-off tax increase is a one-off increase in prices. It is not expected to continue to be present in the CPI, which is an index that measures the current average change in a set of specific prices.
If you are suggesting that the Bank should have adjusted rates such that this one-off movement in consumer prices did not appear in the CPI (i.e. contract before the fact, and expand after), then you need to understand that this is not an exact science (alack), and in any case, even if we could predict exactly the effects of the Bank’s instruments, they operate at considerable lag. Better to just own it, write the damn letter to the Chancellor and worry about the things you can control.
“The overall purpose of QE and the other BoE manipulations was to stimulate the economy. After four years of recession this still hasn’t happened.”
How can you be so sure? Surely you would need to run history again but without any CB balance sheet funny business. If the whole global financial system was left to stand or fall unaided in 2008, would we really be better off at this point?
I agree that’s how the BoE uses it and it is on that basis I am criticizing them. When I talk about the wealth of people in general I have in mind Adam Smith’s broader definition. Obviously, the BoE is affecting the market value of assets and not the cash-flows and this is clear in my article.
Mystery is one of those things that make life interesting. I hope you have fun figuring it out.
Actually, its Mr Spock.
Have another read of the article. You will see this is far from the case.
Are you talking about price inflation/deflation or monetary inflation/deflation. I have clearly explained in my article why monetary inflation is “bad”. Monetary deflation is the inevitable result of a prior monetary inflation barring interventions by the BoE.
I don’t consider movements in prices to be inflation/deflation per se. I explained in my article why falling consumer prices are “good”. It follows that real wages are rising. I am sure you can appreciate a pay rise.
I disagree. There is no room in “theory” for opinion. The “correct” theory “to apply” is the theory based on superior logic and which better explains the facts. The MPC’s “theory” is flawed and was chosen with respect to political expediency rather than logic.
I’ll grant you this. But as you can see, it is implicit in my article and my comments above that I think this notion of achieving a target of 2% is purely arbitrary. As I said before, the BoE should be abolished and the market should determine interest rates. Prices will naturally fall over time. As such, there is no point you and I arguing about whether the BoE has met this particular target or not.
Nobody knows anything for sure. Logic dictates, based on Austrian economics, that we would be better off. Empirically, I consider the example of the Great Depression and the example of Japan, wherein respective governments attempted to “fix” the economy only for their respective depressions to persist.
I fairly much agree with you there. However, I don’t think the boom is caused by monetary inflation alone. It must be monetary inflation without an excess demand for money.
Rising nominal wages don’t necessarily produce “money illusion” if people are aware that price inflation is occurring at the same time. The issue though is that price indexes only estimate very roughly the increase in prices. Things like the CPI and RPI miss out important prices such as the prices of existing assets.
The “primary recession” is unavoidable. If capital has been wasted then incomes will be lower in real terms.
However, there is a “secondary” effect – the effect of the change in demand for money. If the demand for money rises (and in a recession it almost always does) then that will cause a fall in output as I’ve described elsewhere. This effect, what Hayek called the secondary recession *is* avoidable since it stems purely from monetary causes.
I doubt it would be entirely stable, but I think it would be much more predictable than it currently is.
No, changes in demand for cash balances are a natural feature of any economy, just like changes in demand for any other good. The presence or absence of central banking can’t change that. Overall changes can occur for many reasons, improvements in payment processing systems, for example, can reduce the demand for money. Concerns about price shocks coming from external events can raise the demand for money.
In an economy with free banking these fluctuations in demand would be accomodated by the free banks altering the supply of money to compensate.
If fractional reserve banking were banned however then there couldn’t be price stability.
What I was trying to explain earlier is that reductio ad absurdum is a very tricky form of argument, especially in economics.
You wrote earlier:
This is wrong because it ignores supply and demand, it ignores marginalism. That’s why I went on to discuss a physical commodity instead – flour. What I’m saying about flour isn’t an analogy, I’m not saying the flour is exactly like money.
My point was that if you have a process to convert one commodity to another then diminishing returns applies. You write: “Crusoe here is creating value by milling the corn into flour. Sure, the more he mills the less it is worth.” Notice this *isn’t* necessarily true in all cases. If corn has an alternative use (such as use for seed) then beyond a certain point milling it into flour is destructive. In this economic circumstance, and in every other, there are breakpoints. If creating a small amount of something creates value that doesn’t mean that creating a large amount of it does too.
The same general principles apply to money. If there is a large excess demand for money then that can be satisfied by the banking system creating more money. Since money creation can be performed much more quickly than prices can change it is a much preferable solution to freezing the quantity of money and forcing prices to change.
In your example with Crusoe, Friday and Mervyn King there is no excess demand for money. In fact, since you discuss barter I don’t think there really is a money economy.
I’m a little lost by your first sentence here. Which “this” would have the same effect as what?
What you may mean is that preventing the destruction of wealth is akin to creating it, in some ways it is. My point here is that creation of money in this circumstance can make society wealthier afterwards than it would have been otherwise. That’s because the output drop that price deflation would cause would not occur.
I’m not proposing transferring wealth from one group to cover the losses of another, and I haven’t suggested such a thing anywhere here and certainly not doing it by force.
Well, Garrison himself made it in a paper on Austrian Business Cycle Theory, quite a famous one actually “Time and Money”.
Think about the process of unexpected price inflation rather than unexpected price deflation.
In the price inflation case Rothbardian’s like yourself point to the Account falsification/Cantillon effect. In Austrian economics that is a *dynamic* effect, not a quasi-static effect. Account falsification cannot occur in the long run. In the long run prices and expectations will adjust. The point of the argument is to demonstrate that investment decisions will still change and those changes will have an effect in the longer term through an ABCT bubble.
Think about what you wrote earlier “Any supply of money is optimal.” If any supply of money is optimal in the long run and short run then ABCT couldn’t possibly occur. Even if a central bank quadrupled the quantity of money they would only be moving from one “optimal” situation to another “optimal” situation. Clearly this theory isn’t true in the short run.
Back when I was a Rothbardian like you Steve Horwitz challenged me on this point…. How can you say that:
* Money neutrality doesn’t apply in the short run when discussing inflation.
* Money neutrality does apply in the short run when discussing deflation.
Which is it to be? Does money neutrality apply over all periods of time? If you think it does then you must recognise that in that case ABCT can’t be true, “real business cycle theory” is needed. If you believe it doesn’t apply over all periods of time then you can’t use money neutrality as an argument against my position.
“It must be monetary inflation without an excess demand for money.”
Who is to say when demand for money is “excessive”?
Usually people have good reasons for increasing their cash balances.
When I say “excess demand” I’m not criticising people for increasing their demand for money. I’m using a technical term.
When a demand schedule or supply schedule shifts and the price doesn’t immediately change there is said to be an “excess demand” or “excess supply”. There is an excess until a monetary equilibrium is reached. (Which of course is never, markets may tend towards equilibrium but they can never reach it in practice, all supplies and demands constantly fluctuate. “Normality” is just a matter of degree.)
In monetary disequilibrium theory this idea is applied to money itself. If the stock of money is kept constant then:
* An excess demand for money causes price deflation and a unemployment.
* An excess supply cause price inflation and malinvestment which manifests itself later.
Ah yes, of course. Thanks for the clarification, and sorry for the distraction.
Actually Current, I must admit I am bit confused by this term “Excess Demand”. When you use the term “excess” it sounds like a value judgement. Do you mean simply an “increase” or shift in demand? And surely if the demand for a good increases, the price will rise and the market will tend towards equilibrium.
“Excess demand” is certainly not a value judgement. Think of a graph of supply and demand curves that form an X in the centre of the price quantity space. At the centre of the X where the two curves cross is the equilibrium price. Say that for some reason (rent control is the textbook’s favourite) price is fixed below its equilibrium value. We would call the demand at this price “excess”, since, given the supply and demand schedules, consumers want to purchase more than producers want to sell.
Vimothy understands what I mean.
The difference between the monetary case and rent control is the permanence of the situation. In the case of rent control the excess demand becomes permanent. With monetary disequilibrium prices can adjust. But, excess supply or demand can still occur temporarily because prices can’t adjust very quickly.
You will have to explain your definitions of “primary” and “secondary” recessions to me. In my view, there will be one recession and if it is allowed to run its course, it will be short and sharp. Output and wealth will begin to increase once the malinvestments are liquidated. Without monetary inflation, general recessions will not occur without some major adverse external shock. Monetary inflation will increase the length and severity of recessions, as we are currently witnessing.
As you know, I disagree with this. My reasoning is below.
My main question, is that if the BoE can print money and buy stuff, why can’t I? Why is it a crime for me to do this but perfectly fine for the BoE? Why does this ignore supply and demand? If I demand consumer goods why doesn’t make sense for me to just print up some bank notes and go buy them? The answer why, of course, is that this is obviously absurd. And I contend it is absurd whether the BoE does it or I.
Diminishing marginal utility, and supply and demand, only apply to scarce economic goods. Electronic numbers added to a bank’s reserve account at BoE provide no utility. Nothing is being produced. In your example of Crusoe, he is producing something so yes DMU applies. With QE the situation is different.
The point of my Crusoe example is that instead of producing more sacks of flour to exchange for the spear, Crusoe is merely giving Friday sacks of what is essentially “nothing”. He is not using previously produced goods to exchange for other previously produced goods. He is fundamentally, counterfeiting. Exchanging nothing for something. This is exactly what the BoE is doing with QE. Crusoe gains and Friday loses. This is not what happens in a non-fraudulent voluntary transaction
If you don’t like the fact that Crusoe and Friday are bartering we can change the example. Friday’s price for the spear is 4 sacks of gold dust. Crusoe goes to a gold miner and exchanges two sacks of flour for two sacks of gold dust. He then fills up two more sacks with sand and hands Friday four sacks of “gold dust”. Same problem.
For a properly functioning economy, your income is what you produce. You exchange your products for money and then exchange this money for the products you need. You are exchanging something for something. Using printed money created by a bank, not backed by anything of value, for this purpose is exchanging nothing for something.
I agree but the BoE doesn’t do this.
The key is that the banking system creating more money does not create anything of value.
Yes that is what I mean.
If the BoE pays for gilts using valueless printed money this is a transfer of wealth from one group to another without their consent.
I’ll add it to the list. It’s difficult for me to understand the analogy without knowing the context.
Our understanding of “time” is crucial here. In reality there are no “periods of time”. There is no “short run” or “long run”. These are just arbitrary measures that humans use to understand the physical world in which one event occurs either before or after another. Time is continuous with nothing separating one period from another.
My understanding of the phrase “any supply of money is optimal” is that, as asserted by Mises and Ricardo as well as by Rothbard, money performs an exchange function. That is, it is not consumed or used up. So more of it doesn’t provide a net social benefit. More money, does not create more goods and it doesn’t better facilitate the transfer of goods just because you have more of it. More goods, however, will provide a net social benefit. See Dr. Shostak’s article on this very subject, published today on TCC.
The point is, according to Rothbard’s Angel Gabriel model, is that an increase in the supply of money will only be completely neutral if everyone in society receives the new money at once. If this was the case, there would be no ABCT, I agree. However, in reality the injection of the new money is given to specific market participants, at specific times, in specific geographical locations. It requires the passage of time for the new money to have its full effect on prices. For this reason, the early recipients of the new money benefit at the expense of the later recipients. The early recipients are banks, government and large businesses. The later recipients are employees working perhaps for smaller regional or local businesses more geographically removed from the source of the new money. The early recipients are able to spend the new money at close to current prices. The later recipients spend the money, some time later, when prices have risen. Therein lies your wealth transfer and business cycle.
Well, that’s what I just did. I can do it again if you like though…
Let’s suppose we have an ABCT bubble that bursts. In that case the “primary recession” is that caused by the real loss in output. That is, the maturity profile and risk profile of capital goods is found to be incompatible with current demands. In Hayek’s terms the capital triangle has been broken. Some projects must be abandoned and some capital goods reallocated into uses that are less-than-optimal. Notice if this were all that occurs then prices should rise not fall because there is a shortfall of goods.
However, if the demand for money rises which it does during many recessions (though not all) then there are further -secondary- effects. If the stock of money is kept the same then each agent who wants to increase their money holding must do one of three things:
* Borrow money.
* Sell possessions or work extra hours to earn more.
* Spend less out of income.
With a fixed stock of money borrowing only transfers the issue from one agent to another. It isn’t particularly relevant for this problem since the normal reason for a rise in demand for money is increased uncertainty. In most cases borrowing to increase a stock of money doesn’t help hedge against uncertain events.
That leaves the last two possibilities…. Now, if prices could adjust instantaneously then there would be no problem. Spending would fall then straight away prices would fall and equilibrium would be re-established. But, prices don’t adjust like that, there is always a delay. In the interim labour and goods are priced too high in real terms. So, demand for them falls and so we get lower output and employment.
These things are not clearly separated in time. If there is a secondary recession then it is likely to begin before the primary recession has ended. I certainly think that’s what happened in 2008-2009.
It all depends on what you mean by “run its course”.
But, how does the secondary recession help get rid of malinvestments?
Let’s suppose I grow fruit and sell it to the public. My customers are concerned about the future so they spend less on fruit and as a result my output falls. I must cut my prices and my profits fall.
How is this related to any “malinvestment” that I may or may not have been a part of? What magical link ensures that the businesses that are disadvantaged by a rise in demand for money are the ones which were malinvesting?
In the primary recession case certainly things are different. For example, as demand for houses fell in 2007-2008 the demand for inputs into house-building fell too. I expect that did purge some malinvestments.
The key issue connected with malinvestments is whether capital and labour are released from projects that are too long term. By “too long term” I mean that capital and labour is being used in projects that yield less that the natural rate of interest when it could be used in projects that yield more.
However, I think the only way these malinvestments are eliminated is through relative prices and through interest rates (and interest rates are just special relative prices). I don’t think unexpected changes to the price level help to liquidate malinvestments because I see no microeconomic link between them and the malinvestment. So, I conclude that price deflation of this sort during a recession simply damages businesses at random with no positive consequences.
If there were a fixed supply of money then a major external shock would be the most likely cause of recession certainly. But, other things could too, for example if more efficient payment systems were introduced then money demand could fall. That could then cause ABCT.
In my opinion that all depends on the demand for money. If the monetary inflation helps to service a rise in demand then I think it helps.
I think you should be able to, in an ideal world. Others may not accept your currency but you should be able to create it.
My point earlier though was about the non-ideal world we live in today.
In a free market people would be quite free to accept your money or refuse your money. Any who accept it will have to be sure that your money can be exchanged for assets of value in the future. They will only accept your money if it is a debt, a promise by you to pay in the future. And it would have to be a debt they can be pretty certain you’ll be good for. You’d have to have at least an equal amount of assets as you have outstanding notes, and it would be wise to have more in case the value of those assets falls. There would be competition too, others could hold more assets and reserves, they could offer safer money.
This was what my earlier article “Money is barren but occasionally covers us in dust”. Oddly enough I got the impression you agreed with that. But, I see now that you didn’t.
The point of that article was to make clear the differentiation between what economists call “dynamic” theories and those they call “quasi-static” theories. Quasi-static theories concern different economic situations that can be analysed or at least thought about, but they don’t consider movement between those different situations. Dynamic theories do consider the movement between different economic situations.
Certainly the nominal money stock has no special significance. Fiat money isn’t scarce for the government, they can make as much of it as they want. But that doesn’t mean that changing that stock has no effect on the real economy, it certainly does.
To take a similar example… It’s simply a convention that letters are addressed by writing the name first, house second, street third, county fourth, etc. It’s a convention that the stamp is put in the top right hand corner. Now, the government could change that. They could say that on the 14th, 19th and 22nd of each month (unless it’s a thursday or the vernal equinox) addresses have to be written in reverse order and the stamp should be half way along the bottom edge. Would there be any loss by doing this? Physically writing an address would be just the same, there is no change in the use of scarce inputs. The problem though is that people can’t be expected to adjust to this perfectly correctly.
For the same reasons though money may be barren and it may be produced cost-free by a government issuing it that doesn’t mean that it can’t have economic effects. See the sawtooth graph I drew in my article and try to imagine it having no effect.
This phenomenon is common in the social sciences. Often some way of doing some process has no intrinsic value but the fact that we all expect it done in some way and rely on that expectation gives the it value. Language is an enormous example of this, words have no intrinsic meaning.
You are right in part. The BoE produce money from nothing. I would much rather nobody did that, hopefully in the long run we can get to free banking. In the mean time however I still want the BoE to execute reasonable monetary policy. However in this case there is no analogy between opening a sack of corn and finding it full of sand. All our money is fiat currency or priced against fiat currency. The money the BoE issue really is valuable.
The equivalent consequence is that the BoE don’t reduce the stock of money when the demand for it falls again. It seems like in the past few month they haven’t done that and we are in for some unexpected inflation. That’s an error on the BoE’s part, but it doesn’t mean that they were wrong to create any new money. It means they weren’t careful enough about withdrawing it.
Indeed they don’t, and this is one of the problems with our current system.
But, that doesn’t mean that we should urge the BoE to do nothing under all circumstances. You seem to be arguing that because chicanery is involved supply and demand doesn’t apply.
Think about this…. Suppose we have a socialist state where the government control farming centrally. There are commercial farms that the government don’t own, but their output is still controlled indirectly by the government. Now, should we urge the government not satisfy demand for food? No, that would be foolish, what we should oppose is the government owning the farms in the first place. But so long as they do own them we should support price policies that are as reasonable as we can get. We shouldn’t argue that a fixed output of food would be suitable in all cases and that the government shouldn’t adapt prices to fluctuations in supply and demand.
The situation with central banking is the same. We may object to the corporatist way that it functions. But, that doesn’t mean that all of it’s functioning is undesirable.
When banking reformers propose to freeze the quantity of money to eliminate the evils of central banking I can’t help wondering about the old American south before the civil war. Did anyone propose to end the evils of slavery by freezing the quantity of sugar and preventing it’s creation or destruction?
But, the money the BoE pays for gilts has value doesn’t it? Certainly it’s fiat money but that doesn’t stop it from having value. Money doesn’t have to be redeemable to have exchange value.
Unfortunately Garrison isn’t very clear in his paper about that analogy. I recommend reading “Time and Money” though, it’s very good.
Garrison may be more clear in the book of the same name, I haven’t read that.
When I say “short run” and “long run” I’m not thinking of particular concrete lengths of time. It’s more a topological categorization. When I say “short-run” I mean the time period during which dynamic effects are still important. We are always in both the “short” and “long” run, but at any particular time the effects of certain past events have either being incorporated into market prices or they haven’t yet being completely incorporated. We can safely say that the outcome of the battle of trafalgar has been incorporated into market prices, the outcome of the deposing of Mubarak perhaps hasn’t.
As I’ve said earlier, be careful when quasi-static ideas are mixed with dynamic ones. Certainly money provides an exchange function, it may not get used up (though coins do wear out), and money doesn’t produce more goods. I said all of this in my article. But, all that doesn’t mean that changes in quantity can’t facilitate trade, that’s a different, *dynamic* question.
It’s originally from David Hume, not Rothbard. (Rothbard mentions this).
Yes, that’s right. Specifically this is a criticism of Hume’s idea. You then go on to explain why money is non-neutral and explain the effect of slowly changing prices. How can you believe all this and still write what you’ve written above? What you’re trying to do here is hold on to only one part of a larger dynamic picture and reject the rest.
I agree that prices change slowly and the effect of money injection follows gradually, I agree with the Cantillon/Account falsification effect. I also think that same applies to money withdrawal. When people accumulate money from their income the same process you describe applies in reverse.
I think your viewpoint is asymmetrical. In my opinion when money reserves are spent they cause a gradual increase in prices that spreads out across the economy. When that increase isn’t expected, people buy at the current price level unaware that prices will have increased when the movement has ended. There is an “excess supply” of money in the technical sense I described earlier. This causes the ABCT boom you’re familiar with. So far we agree, but I’d go further. This logic also means that if money reserves are being accumulated then the opposite occurs, there is a gradual decrease in prices that spreads out in a similar way. People buy at current prices unaware that prices will have decreased when the movement has ended. There is an “excess demand” for money, and this causes a secondary recession.
In the sub-thread on excess demand you wrote:
Notice that I could argue the same about excess supply which is what your explanation of injection effects entails. If there is an excess supply then the price will rise and the market will tend towards equilibrium. Yes, that will happen, but in there is a lot of room for mischief in the time before prices have moved to allow it to happen.
I do like, thank you.
With respect, your fruit example is a little too simple to illustrate the problem. As a result of malinvestments, your customers may spend less on expensive extravagant desserts and more on cheaper fruit. The recession may benefit you. Further, your customers will not be permanently concerned about the future. Once the liquidation stage is complete they will start to become more optimistic.
In any case, there is no need for a magical link to ensure the malinvesting businesses are “punished”. To an extent all participants in the economy benefit from the rising tide of monetary inflation. And depending on how high they rose on the wave, they will fall back down accordingly. The biggest bubble will have the biggest pop.
It is inconceivable that output would stay permanently depressed if this government intervention (monetary or otherwise) does not occur. Humans must act and as actors they require maintenance (food, clothing shelter, etc.). Humans also act to improve their situation. Thus, once malinvestments are liquidated and order is restored, work will begin on investments that are fully supported by real and voluntary savings.
In fact, I would go further than this. The government intervention itself (through monetary inflation) will slow the liquidation process by providing support to malinvestment projects. Rather than being liquidated, the projects will continue, with more good money being thrown after bad, and the process of capital consumption continuing. The necessary rise in real wages will not occur thus people continue to become poorer while the recession drags on and on. Furthermore, this transfer of capital to malinvestments will increase the cost of capital for efficient projects. The result is that many wealth enhancing projects will not be commenced while wealth destroying projects will continue.
Rather than assisting with the purge of malinvestments from the economy the government intervention will slow the process making it more difficult for capital and labour to be disentangled from these wasteful projects and be reallocated to new, wealth creating projects.
To my understanding, malinvestments will quickly be revealed based on accounting losses, falling market values of assets and negative cash-flow (this embodies the relative price changes). They will be liquidated because it is simply impossible, without government intervention, for them to continue. Banks will reduce lending and call in loans (monetary deflation), and businesses will be put into administration because they cannot pay their bills as they fall due. The fall in consumer prices (which we both define as price deflation) will be a symptom of the malinvestment, rather than a cause. Prices fall not just because of falling demand but because businesses need to liquidate excess stock of goods produced in error.
It is not obvious that the fall in prices will be unexpected. If businesses are liquidating projects and retail outlets need to reduce stock and close stores surely it is obvious that prices will fall? It is not for nothing that retailers constantly advertise “Closing Down” sales during recessions. People know that this means a “fire sale” is in process and actively look to take advantage of the sudden availability of extraordinary bargains.
Most participants in the economy will be disadvantaged by the period of uncertainty that results and many through no fault of their own. But I maintain that this is a consequence of the prior inflationary boom and that it is unavoidable. Likewise, it will resolve itself because humans must act and humans must consume in order to continue acting.
Increasing the supply of money at this stage is akin to giving more alcohol to a drunk. It will make the problem worse.
A fall in the demand for money would not cause ABCT. It would merely result in a new higher equilibrium price of goods (the opposite of what would happen with a increase in the demand for money). This is (partly) because there is no transfer of wealth and no (monetary) inflation.
I think we have a disagreement here about what money is. I do not consider money to be a debt. For example, if my money is a debt what is it a debt for? If I mint gold coins and use those as money where is the debt?
This confusion about what money is stems from the practice (beginning in the 16th Century where Europe is concerned) of goldsmiths and/or bankers issuing receipts for gold held at the bank. The point is that if, in a free market, I merely print up some notes and try to pay for goods with them I would be locked up; either in prison or in the funny farm. Unless of course, my notes were backed by a specific quantity of goods i.e gold (and in this case, the value of those goods/assets would be immaterial because gold is the money not the notes themselves). The notes are merely the facilitator of the transfer of the ownership of the gold.
The BoE notes are backed by nothing. Thus they promise to pay you more banknotes in exchange for the banknotes they originally gave you. An absurd situation.
But I don’t think we disagree about this.
The money that the BoE has value but it is value imputed to it, by fiat. It has the same value that the sack of sand had to Crusoe. He was able to exchange it for a spear. And the sack of sand was valuable to Friday until he got around to opening it and realised he had been duped. Crusoe transferred wealth from Friday to himself without Friday’s consent. Likewise, the “value” in the BoE’s money represents a transfer of wealth from you and I, to the BoE and its clients.
This is different to the “value” that you and I create by performing a useful service for someone else, that improves their condition and in return being paid for it (ideally with a economic good, like gold). Printing banknotes creates nothing of value. They can only represent “value” if they are backed by an economic good. The BoE notes are not backed by anything.
The government cannot satisfy the demand for food. This is down to the entire “economic calculation” argument given by Mises. Likewise, the BoE cannot satisfy the demand for money. The BoE will and does run into the exact same problem as any socialist enterprise. It simply cannot determine what the right amount of money should be.
I am not arguing for a fixed quantity of money. That is impossible. I am simply arguing that CBs should not be meddling in the supply of money for all of the reasons given above.
Actually, what Rothbard says is that Hume and Mises used similar models but Rothbard was the one who named it the Angel Gabriel model. I am referring to Rothbard’s version of the model.
OK now I understand where you’re coming from. I can reconcile this however. We need to separate the value and purpose of money (as an enabler of voluntary exchange) from the effect that changes in the quantity of money have on the economy. What I have said about the creation of money is a fact. It does not create more goods as you have agreed. Increasing it does not better facilitate the trading of goods because it does not increase the speed of exchange, quantity or quality of goods.
Increasing it in the manner of the BoE does have an effect, no doubt about it. But it is the effect you would expect from fraud. Some people gain, other lose but this fraud, effectively counterfeiting, does not facilitate trade. It is a non-voluntary transfer of wealth from one group in society to another. It has specific effects at specific stages of the production cycle because of the specific locations or participants to whom the new money is given.
I am not holding two contradictory views of the neutrality of money partly because neutrality of money as a concept is not compatible with the Austrian view of capital theory (per De Soto) nor does it consider the endogenous money created by banks. It is not the concept to use to suggest I am in contradiction. To say that increases in money do not increase wealth (essentially my argument) and that increases in money by the BoE (in the manner described above) create distortions in the capital structure is perfectly consistent.
The only thing I would say in addition is that I think that there is an actual asymmetry here between the demand for money and the supply of money (where this supply is provided by a CB). Changes in the demand for money represent a general and gradual shift in the attitudes of market participants. Changes in the supply of money are the sudden result of one single government agency’s arbitrary decision. It’s not hard to see why the effects of each are so uneven.
Sorry, I was a bit unnecessary in my previous comment. Rereading your post it seemed as though you made some extraordinary claims about the BoE and UK monetary policy that reflected more a set of partisan positions rather than ones grounded in any sort of evidence, extraordinary or otherwise. I do find the online debate frustrating at times, because of its naked and generally pretty predictable tribalism. Some of that frustration came through in my comment and for that I apologise.
It may help to think of a simple model to understand what the Bank is trying to do. Say that the demand for real money balances is a function of the nominal interest rate i and real income Y, so that we can write the equilibrium condition for the money market as M/P=L(i,Y), where M is the nominal money stock and P is the price level. This implies that the price level is given by P=M/(L(i,Y)) . (Define inflation as the growth rate of the price level, or the derivative of the price level with respect to time, divided by the price level.) Notice that, for given values of i, Y and M, an increase in demand for money will lower the price level, which is deflation (more precisely, the growth rate of the price level is negative). Notice also that we could offset this increase in demand by increasing the size of the nominal money stock, and so prevent the price level from changing.
So you can look at QE as the Bank increasing M directly to stabilise P (actually, the growth rate of P) following an increase in the demand for money (caused by the uncertainty generated by the financial crisis). You can also look at QE as the Bank trying to reduce this precautionary demand against any given quantity of money by increasing the nominal value of society’s financial wealth.
Consider the supply function of the money stock. If the price elasticity of supply is totally inelastic, any shifts in demand will result in large movements in the price level, producing inflation or deflation (defined as positive or negative price level growth rates) depending on the direction of the shift.
In equilibrium, whatever the particular level of the money stock it is “optimal” in the sense that the system is stable. If the system is not in stable, then it no longer makes sense to think of this stock as optimal. If the demand for real money balances increases for given Y and i, and taking the money stock as fixed, we solve the system in terms of P (i.e. prices fall). But the initial level of M has no intrinsic value outside of the equilibrium. If the costs of price level movements are higher than money supply movements, since there is no a priori reason to prefer one to the other (we are indifferent to the particular level, but would prefer to be in equilibrium), stabilising the price level and solving for M is the more optimal policy.
“I agree that’s how the BoE uses it and it is on that basis I am criticizing them.”
In the OP, you criticise the Bank because they believe that their policies will increase wealth in the Adam Smith sense when this belief is in fact mistaken (“The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value”). The latter half of your statement is true (money is not output), but the former is false. That is, the BoE’s staff do not think that printing money and rising prices mean that they are creating value. They think it means providing price level stability (specifically, that the growth rate of the price level is stable and low).
“Are you talking about price inflation/deflation or monetary inflation/deflation. I have clearly explained in my article why monetary inflation is “bad”. Monetary deflation is the inevitable result of a prior monetary inflation barring interventions by the BoE.”
I’m taking about both. You explained that “monetary inflation” is bad because it prevents “price deflation” and causes “price inflation”. You explained that if prices are rising then real wages are falling, but this is incorrect. Inflation is the growth rate of the level of all prices, and wages are the price of labour. If all prices are rising (i.e. the price level is rising), then wages are rising as well, and the real wage is constant. (In practice of course, the rise in prices is not uniformly distributed in space and time—the most common measure of inflation does not capture this well because it is merely the average of all the observed price movements in its indices—and we have something like the injection effects mentioned elsewhere on the thread). You write that, “The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power”. It should then also reduce its purchasing power in terms of the ability of firms’ ability to purchase labour.
Why should we prefer the price level to be moving at one rate as opposed to another? No reason at all unless there are costs associated with these different growth rates. One outcome that is likely to be costly is if the actual growth rate of the price level is different to its expected rate. For example, if you had lent money out at 5%, expecting 2% inflation, a move in the actual rate of inflation of 3 percentage points either side would double your return or wipe it out completely. It is easy to see how this could have significant costs for the economy if it was experienced widely. On the other hand, it is impossible for everyone to be made better or worse off in this fashion. So the direct effect is not to create or destroy wealth but to redistribute it. And it’s the deviation from the expected rate that implies a potentially costly redistribution of wealth, not a particular sign or value of price level growth.
But think of what it would mean if the relative price of output rose against its inputs. Those inputs are now more productive, which has two implications. Firstly, taking demand for output as constant at the new price, that the optimal level of inputs for a profit maximising firm has increased, which should bid up the price of those inputs (demand for labour increases). Secondly, that since the suppliers of factor services are also the demand side in product markets, firms need to price their output competitively relative to the return to the factors of production to clear the market (demand for goods and services falls).
“The “correct” theory “to apply” is the theory based on superior logic and which better explains the facts.”
I suppose this also happens to be your own particular theory?
“The MPC’s “theory” is flawed and was chosen with respect to political expediency rather than logic.”
Can you be more specific? When you described the MPC as “Keynesians” and wrote that they think printing money is wealth creation, I got the sense that you weren’t really concerned with the theoretical reasons for MPC decisions, but I would certainly be interested if you have a critique of some of the models they use.
“But as you can see, it is implicit in my article and my comments above that I think this notion of achieving a target of 2% is purely arbitrary.”
In a sense it is purely arbitrary. In the same sense, 0% or –2% might also be acceptable (although there are reasons for preferring 2% to 0% or –2%). But having arbitrarily chosen a particular rate of growth for the price level we would then like the central bank to make a binding commitment towards achieving its target and then bloody well achieve it (so that actual inflation equals expected inflation).
“Logic dictates, based on Austrian economics, that we would be better off.”
“Empirically, I consider the example of the Great Depression and the example of Japan, wherein respective governments attempted to “fix” the economy only for their respective depressions to persist.”
Both those examples suffer from the same problem—they were not controlled experiments—and so do not constitute good proof of your position. As you surely know, like the recent financial crisis, they are used as regularly as examples of the failure of free markets as of the failure of government intervention. Obviously, both interpretations can’t be correct—although they can both be wrong—but which is it? I think that in the final analysis this is a question of judgement: there is no decisive scientific way to resolve this question while we have no spare parallel universes in which to run controlled historical experiments.
As you’d expect I agree with almost everything you’ve said.
I don’t think that we should yield the question on logic though. To say that only long-run quasi-static effects matter is logically coherent even if it’s empirically invalid. But, once someone admits one dynamic effect into monetary theory, such as injection effects, then logically they have to let in the rest because they’re all similar. They can argue that the rest aren’t empirically important, but only that they can’t logically remove them from the picture.
Anyway, I’m going to put up an article about this soon.
“The BoE notes are backed by nothing.”
BoE notes are backed by the Bank’s assets, and, ultimately, by the ability of the government to raise taxes. In practice, the pound is not a pure fiat currency.
“ultimately, by the ability of the government to raise taxes”
Taxes in £’s, no?
I haven’t thought about it enough, but it sounds circular to me.
This is a part of the Chartalist argument, which is difficult. I’m planning to write an article about it soon.
There are various explanations for why money may have come into existence. But, regardless of exactly how that happened way back in the past there is the question of what forces ensure money continues to be used.
With modern currencies (and you can call them “fiat” or not) the way it works is that the treasury can create bonds. It can create bonds because it has an income from taxation. The states power to tax ensures it can create high quality debt certificates. Then in one way or another these are passed to the central bank. The bank then uses them as assets to back the notes and reserves that is issues. This situation is further bolstered by legal tender laws, and more importantly by tax laws that require taxes to be paid in legal tender.
I’m willing to agree with Neo-Chartalists this far, though not much further. (I think Mises’ view was similar, if you’re interested see Appendix A of “Theory of Money and Credit”.)
There is are elements of circularity here. The system can break at several points. For example, a government can start printing unbacked money, that can cause fear of inflation. Or, fear that a government won’t be able to obtain real assets by taxation can make bonds worthless. It’s essential for things to work this way that taxation has enough real not just nominal value and it’s essential that bonds have enough real not just nominal value. Without that the only forces that would keep money in circulation would be inertia, legal tender and tax laws.
The German hyperinflation of the early 1920s is a good example. The German issued a great many bonds. So many that the markets considered that they had no politically feasible way of paying them back in the future, the implied tax rates would be too high. That made the bonds junk bonds. So, the German government sold them to the central bank, which considered them as being worth face value since it was a branch of government. The bank then issued notes against those bonds so it could buy more. This is what created the hyperinflation. It shows that the separation that independent central bank accounts give isn’t that robust. (Though it’s still better than governments printing money directly, which is completely opaque).
Cheers Current. Looking forward to your article. I really do need to find time to read TMC.
But everyone on the thread agrees that money has no value in and of itself, so why would the govt want to tax £s?
My fruit example wasn’t intended to convey all of the details of malinvestment. It was just intended to show how any business can suffer from the effects of a fall in the money supply below the demand for it.
You are right that if the wealth of my customers has fallen due to the primary recession then I may benefit or I may lose. That depends on whether I sell luxury goods or cheaper substitutes for luxury goods. I was talking about something different though: the effect of changes in money demand.
Looking back at my previous reply I see that I wasn’t very clear. What I was meaning to say in the fruit example is that my customers wish to increase their stock of money because of uncertainty over the future. Let’s suppose their income has not substantially changed, all that’s changed is that they each demand a higher money balance. Note when I say “demand” here I don’t mean “desire” I mean demand in the economic sense, they are willing to pay for their money by selling assets or making contracts about the future (that is borrowing).
Now, if the monetary system can’t furnish that demand then my fruit selling business will suffer. My question is: why is this good?
But, exactly the same thing is true of a business that has misallocated capital. As I we’ve mentioned above during an episode of ABCT some businesses expand roundaboutness to unsustainable levels. So, when the real interest rate rises these businesses aren’t profitable enough to survive (or are too risky to survive). Also, as the ABCT boom increases the illusion of wealth spending on luxuries increases, then later when the bust has begun people recognise that they can’t continue spending the same on luxuries. (Roger Garrison has a good diagram for explaining this).
Now, once the bust has occurred guys like me say that misallocations are cleared by the long-run interest rate rising and making low profit/high risk investments no longer worthwhile. Guys like you say that too, but also say that price deflation causes “purging” and helps too.
(I’m assuming you agree with the first part because later you write: “To my understanding, malinvestments will quickly be revealed based on accounting losses, falling market values of assets and negative cash-flow (this embodies the relative price changes). They will be liquidated because it is simply impossible, without government intervention, for them to continue.”)
The first problem with this theory of deflation is that a good business is just as likely to be in the direct firing line here as a bad one. There’s no reason to suppose that a rise in money demand occurs in a way that’s particularly related to prior misallocation. It’s difficult to predict which businesses will be affected.
Secondly, as we have discussed before, this episode of price deflation can only have temporary effects, just as price inflation does. In the long-run the quantity of money doesn’t matter. The temporary effects of the rise in demand for money will spread out across the economy, and the price level will fall unevenly. In time the effect of that fall will be incorporated into decision making and account falsification will end.
Why should businesses that haven’t misallocated survive the temporary deflation better than ones that have? The only possible reason is that the former have higher profits. But, businesses with higher profits already have a substantial advantage even without price deflation.
To put it another way… The laissez-faire approach of a rising real interest rate specifically disadvantages those businesses that are more risky and/or less profitable. The 100% reserve approach of a rising real interest rate coupled with price deflation does the same thing, but it also disadvantages some randomly selected set of other businesses too.
In my view, if you want to claim that those businesses that malinvested “rose high” and will therefore fall the lowest then you need a theory to back it up. It’s not intuitively obvious.
I’m not arguing that it would. I’m saying that output would be restored more quickly with intervention. This is just the specific case of central banking as we have it today. In our current world there is no market force to ensure that money supply and demand meet. The market forces have been nullified by central bank instruments such as OMOs, the discount window and reserve requirements.
In my view there are two situations you are conflating:
* Central Banks create money when there isn’t excess demand for it, when there’s excess supply.
* Central Banks create money when there is excess demand for it.
These two situations are quite different. In the first case the central bank is causing account falsification but in the later it’s preventing it. I’ll go into more detail about this in the article I’ve got in the works.
That may happen…. In this recession it has happened, in may past recessions banks have come through without great problems.
As George Selgin points out elsewhere on this site the situation where customers lose faith in banks entirely is very rare. It may never have happened outside of countries with restrictive banking regulations.
Often banks are not in such a bad position in recession exactly because people demand money substitutes. Banks can issue those substitutes and profit from that. A bank that has a valuable loan book (as oppose to one full of toxic waste) can be in a good position in a recession.
I don’t think it always will be, deflation wasn’t widely expected in the US when it happened. When it is expected you’re right, it’s not a great problem.
But, I think you’re only looking at one side of it here. Those assets that have been misallocated will fall in price. Fire sales will occur as you say. As Greg Ransom is continually pointing out on Coordination Problem, some proportion of the misallocated investments will be unrecoverable. Their value after maintenance is factored in will be negative so they’ll be abandoned. But, on the other hand demand will rise for everything else.
If you think about it carefully whenever we say that demand for some good rises and that’s all that happens then we must be also saying that demand for money also falls. Similarly, when demand for some good falls and that’s all that happens then we must be also saying that demand for money rises. Demand for money can only stay the same if the demand for one good rises and another falls in correspondence.
Normally, when there is a shortage of something it’s price rises. Similarly, when there is a shortage of a great many things then we should expect prices to rise. Why then do you think that it’s natural that prices will fall in this particular case of a shortage caused by an ABCT bubble bursting? As you point out some assets become worth less or nothing, but generally there is a shortage in real terms not a surplus.
If you think about it, if all that happened was a fall in wealth and output then (ceteris paribus) all prices would *rise*. That’s the primary effect. The reason they often don’t rise has it’s roots in the secondary effect, the rise in demand for money.
One of the perculiarities of this analogy is that it’s wrong about alcoholism as well as monetary economics ;). The recommended treatment for alcholism isn’t to stop all at once, it’s to stop gradually. Because of the nature of the dependency it builds up doing that is very dangerous even if it’s possible, it can cause a heart attack.
The situation isn’t really analogous for the business cycle, but it’s interesting that this common analogy is mistaken.
Why do you think that? How can account falsification be avoided in this case?
Notice that explanations of injection effects begin with monetary inflation, but they depend on the price level and on price inflation. I’m going to say more about this in my article, so I won’t say so much now.
I agree that money can be a commodity or a certificate signifying ownership of a commodity. But, that’s not my point here. My point here is that if you want to issue your own money then at the very minimum it must be a debt. (Some claim it could also be a form of shares, but this has never really worked in practice).
This is a myth, read George Selgin’s paper “Those Dishonest Goldsmiths”. There is no evidence that Goldsmiths hid the fact that they were lending money out from their customers. Even the harshest critics of the Goldsmiths at that time didn’t accuse them of that form of fraud.
That’s too limiting a case. Yes, if your notes gauranteed nothing then no-one would accept them and you’d be considered a bit eccentric. But, you don’t have to go all the way to backing notes 100% with a commodity for them to be accepted. In all known instances of free banking fractional reserves were used and banks held assets against notes as well as gold.
At the bottom of this thread I wrote a post on this to Vimothy and Mrg.
No, nothing analogous to this happens with a fiat money system. The “sack of sand” is never opened.
In a ABCT bubble, (a situation of unexpected inflation) yes it does. In all situations there is the seigniourage taxation caused by long-run price inflation.
But, in a recession these are small concerns. The demand for money is a much larger one. I’d much rather the BoE be abolished, but failing that I’d rather that it meet the demand for money even if in doing that it defrauds us a little.
Note that under all circumstances in central banking the government control the reserve ratio and the rate on reserve borrowing. The central bank cannot “not intervene” it is constantly intervening. It is constantly coercing the banks too by making them obey it’s regulations, just as it’s coercing us when the redistribution you mention above occurs.
I agree. But, that doesn’t mean that it’s completely impossible to understand even roughly, it isn’t. The Soviet Union’s commissars knew roughly what the demand for food was even if they didn’t know the exact details. Not knowing the exact details throughout the economy was their undoing. For one asset – money – it’s simpler, though still far from optimal.
So, as long as we have a world without free banking I’d rather central banks be roughly right than do nothing and be precisely wrong.
Well, AFAIK Hume presents this idea using the example of the Angel Gabriel giving money to people in their sleep. I think the difference that Rothbard want’s to show here is that Mises was more concerned with injection effects than Hume. Rothbard may have been the first to call in the Angel Gabriel *model*.
But, one amount of money may better meet people’s expectations than another. Just as one consistent style of addressing envelopes may better meet people’s expectations. The dangers of unexpected price inflation and unexpected price deflation are similar and opposite. In the first case account falsification happens in the direction of exaggerated profits as people are not immediately aware that the value of money has changed. In the second case account falsification happens in the reverse direction.
The term “neutrality” began with Wicksell, who was an adherent of Austrian Capital theory. He talked about “neutral interest rates” and “neutral money”. Hayek used it too, he popularised it. You’re right there are problems with this concept. Hayek describes them in “Prices & Production” and “The Monetary Theory of the Trade Cycle”.
But, notice what I’m saying here, my point is that money is non-neutral. The main problem with neutrality lies on the side of the positive statement: it’s difficult claim that money is neutral.
But if you’re saying that it doesn’t increase wealth and it causes destructive distortions then you’re saying that it decreases wealth in the long term. That’s fair enough, and I agree. But, it’s a dynamic theory that involves a long-run and short-run part. If you’ve got one of those for inflation then what about deflation? If you’ve got one for a case of stable money demand then what about changing money demand?
You can’t dismiss the dynamic theories of other folks just by quoting the quasi-static part you mention above (ie increase in money supply don’t increase wealth). If you’ve got a dynamic theory then logically you have to examine other dynamic theories too.
I’m going to discuss this more in my article.
Generally yes, but not necessarily. Large changes have been seen before. Velocity isn’t a perfect measure of this, but statistics on velocity show that it has occurred.
Milton Friedman long believed that velocity was constant, in his models that meant demand for money was constant too. He based monetarism on that idea. But towards the end of his life he changed his mind when statistics showed otherwise.
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