This article was first published at the Adam Smith Institute on Saturday, 30 July 2011
At the Hayek v Keynes debate at the LSE on Tuesday, George Selgin probably raised a few eyebrows when he pointed out that Hayek would, in theory, have been in favour of quantitative easing to prevent a deflation. That doesn’t really chime with the extreme do-nothing image many people have of the Austrian school of economics.
Yet as Lawrence White pointed out in this paper, Hayek’s position on the correct monetary response to a downturn is more nuanced than is commonly imagined:
Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.
Essentially, Hayek wanted money to be ‘neutral’ and that meant that it had to be constant. For it to be constant, changes in velocity had to be offset by changes in the money supply. The central bank should not, therefore, permit the kind of monetary deflation that occurred after the crash of 1929 to take place. On this basic point, there is actually little difference between the Hayekian view and the approach taken by Milton Friedman.
Does that make Hayek an apologist for central planning? Well, not exactly. Those in the modern free banking school (like Lawrence White and George Selgin) would argue that in a wholly denationalized banking system, private banks would react to a fall in velocity by issuing more base money (if people were hoarding cash) or by reducing their reserve ratios and lending more (if people were sitting on large deposit balances). That would achieve the constancy of the ‘total money stream’ that Hayek favoured, but would do so spontaneously rather than according to some central plan.
The argument goes, therefore, that central banks should try to mimic this process if faced with the same set of circumstances. Hence Selgin’s comment that Hayek would have favoured quantitative easing. But note that he only said ‘in principle’. In practice, there are a whole host of other considerations.
Firstly, central banks have limited information. As with all central planners, their chances of replicating the outcomes that would prevail in a free market are slim. Secondly, modern central banks tend to have a strong bias towards inflation. The upshot of these two points is that a policy like QE should only be pursued when the downside of doing nothing outweighs the potential cost of getting it wrong. Outside of severe crises, that’s unlikely to be the case. Thirdly, QE as practised today (using ‘new’ money to buy government bonds from a bust banking sector) might not be the best way of achieving the objective of monetary stabilisation. The old-fashioned Bagehot rule – providing liquidity support to solvent banks at a penalty rate – might well be preferable.
Finally, it’s worth stressing that the Hayekian / Free Banking approach is not about stimulating the economy, or bailing out failed institutions. It does not aim to re-inflate old bubbles, or create new ones. Nor is the idea to support wages or prices. The goal is simply to create a stable monetary environment so that economic adjustment and recalculation can take place.
Just a little confused and hoping for a good comment page.
Elsewhere today you cite the Austrian metric saying that the UK money supply is continuing to contract – obviously not the monetary stabilization Hayek is seeking.
Here you say that policies “like QE should only be pursued when the downside of doing nothing outweighs the potential cost of getting it wrong. Outside of severe crises, that’s unlikely to be the case.”
OK, so, just to be clear, with this being the most severe crisis in our lifetimes, we qualify for corrective monetary actions.
But QE? Well QE is the only tool in the central bank toolbox, given the ZIRP policy of years running.
To me, what is needed is either something like the MMT schools fiscal adjustments, with non-debt-funded deficits, or full-blown reform of the monetary system so that Treasury has the capacity to inject money into the economy in a manner similar to MMT. The difference would be the latter is driven to stable monetary and economic activity and the former toward society’s full-employment goals.
The question for Hayek and Cobden is, given the crisis and at least Hayeks and possibly Cobden’s embrace of monetary policy actions, what actions would be appropriate from the Austrian business cycle book?
Good Evening Jobhed,
I refer you to my comments to Tom enclosed.
I as chairman of the Cobden Centre would never , ever, endorse QE or any money policy that was not conducive to a hard money policy.
There is a branch of the Austrian School who may, and I really do stress the may, consider under very select , last roll of the dice circumstances a QE policy. I am not one of them, Tom seems to be going down that line.
We have no corporate line and are not Stalinist , thus any of the wider Austrian family are always welcome to say what they think.
Joebhed, a little bit more clarity for you here and Tom, you may like to consider this as well. This is a quote taken from Selgin’s Theory of Free banking
“George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 4: Monetary Equilibrium
A contrasting view of bank credit appears in the writings of several of the Austrian economists, especially Ludwig von Mises, who give the phenomenon of forced savings a prominent place in their elaborations of the monetary theory of the business cycle. According to these writers any credit expansion or increase in the supply of fiduciary media—inside money not backed 100 percent by reserves of commodity or base money—is unwarranted. “The notion of ‘normal’ credit expansion,” according to Mises, “is absurd”:
Issuance of fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion.
In other words, all net expansion of fiduciary credit is a cause of loan-market disequilibrium. It causes bank rates of interest to fall below their “natural” levels, leading to forced savings and other trade-cycle phenomena. This contrasts with the view defended here, which holds that no ill consequences result from the issue of fiduciary media in response to a greater demand for balances of inside money. According to the latter view it is perfectly possible that fiduciary media may arise from loans or investments involving transfer credit only.”
So Mises, probably the most important of all the Austrians took a different view to that put forth by Selgin and White. The elegance of what they say contra Mises is that if you absent a central bank (as I think you will find they probably would agree with Mises with a central bank!), in a free banking environment, that should be classed as “mature,” then if on the one hand cash balances rise and spending goes down, the free banks have more cash with which to issue as loanable funds to business. This would appear to square the circle.
I would counsel caution here. We know historically following the brilliant work of Checkland on the Scottish Free banking period that there was boom and bust periodically on a regular basis. So what was causing this to happen? We know that option clauses allowing banks to suspend the payments of their obligations happened on a frequent basis, so why were the banks not able to match savers with investors in such as way so all the time preferences of everyone were broadly speaking aligned ?
My own personal view is that what an economist calls savings, is any abstention from consumption, thus if you hold a precautionary cash balance , you are saving. To a layman like myself, I do hold precautionary cash balances, indeed i am very scared re the whole economy right now! I hold cash as I do not know what will happen. This is the most uncertain time I have ever known and so many things , so many businesses are so expensive, I would rather sit out this part of the cycle and keep my powder dry. But my money is being lent to others, who will produce goods and services and the recession will continue to hobble along and maybe get deeper, rather than correcting . Thus, my precautionary cash balance is doing exactly the opposite of what I want it do be doing i.e. nothing! So this mis alignment of saving and investment for sure will happen writ large across the economy will mean that the fractional reserve free banking system , whilst being a great step forward in theory, will in practice not manage to stabilise MV as suggested.
However, after thinking about this, I think they way forward to address this issue in the Austrian community of free bankers, as one thing for sure is , we are all free bankers, it is just a question of what type of free banking we opt, is to ask ourselves the following questions;
Fractional Reserve Free Bankers (FRFB) can you acknowledge the above and if you do not think this is a problem, please specify why?
100% Reserve Free Bankers (100%RFB) , say if all parties to a contract are fully aware of what they are getting themselves involved with and there is no state support what so ever, why not say caveat emptor and let people get on with doing what they want to do?
It seems to me, the basic function of banking is to provide a safe place for your money, and services of mediation between savers and borrowers, facilitating transaction / payment services , providing trust and custody services and that is about it.
Our survey of 2000 people showed us that most people are confused and only 8% knew that when they deposit into their bank, they engage in an act of lending to the bank. To avoid confusion I would suggest the follow happens;
Banks who which to cater for the fiduciary and transactional business only i.e. the save keeping, the trustee work, the custody work, the timed savings and timed lending , payments , do so as Fiduciary banks. These are 100% reserve free banks. Trust banks and savings banks in the UK were very mush of this tradition. Andrew Lilico has written on this matter.
Banks who wish to be a little bit more racy and borrow short and lend long and play the game of large numbers, very specifically set up that way, and be very explicitly none fiduciary i.e. be a commercial enterprise and rely on no state apparatus to hold you up like the rest of us and function therefore as described and the Theory of Free banking does.
I believe this separation than corrects the precautionary balance point I mention above as they would move to fiduciary commerce banks as opposed to the FRFB variety, (the significance should not be under estimated as there ate 100’s of billions if not trillions of cash balances in fund managers and on corporate and personal balance sheets waiting for the correction to happen,) and smooths out many of the business cycle enducing tendencies of FRFB . It is consistent with private property rights pro libertarian thinking and people who want fiduciary 100% reserve free banking services get what they want, re banks of commerce who safe keep your money , lend on a timed basis if you put in for that, safe keep if you put in for that, but at all points in time you are very much plugged into the international payments system and in control.
Thus both sets of free bankers should be able to advocate a united policy of an end to central banking and a proactive move to free banking.
Just a little thought………………
Good Afternoon Tom,
It is a great pleasure to have you posting here. I would like to highlight some points I have issue with that you might like to reflect on.
“The upshot of these two points is that a policy like QE should only be pursued when the downside of doing nothing outweighs the potential cost of getting it wrong.”
When people hold more cash balances as they do now, for a whole variety of reasons, such as they are scared that there will be a further down turn, they think prices are still far too high, they will spend less on existing goods and services . Existing producers of goods and services and sellers of labour need to adjust their cost base back accordingly. This is a painful process. This is also a quick process if the government does not drive to intervene and save business where their product is too expensive, or for home owners who have too higher price expectations for selling their homes etc. The wonder of the market is that if left to clear , it will. The inefficient and too highly leveraged Lehman Bros good assets, within days were re allocated to people who were better users or allocators of capital.
The state gets involved with supporting the highly leveraged RBS for example , whose claim to fame now is being the largest loss maker in British history, is kept alive in its zombie format. As long as we keep zombies alive, we will not get out of the mess we are in. The market will not correct. So I submit, there is indeed no time at all where not letting the market correct would warrant a does of money creation to keep MV constant . If we decided that we wanted to do this as a proactive policy response, then we would create potential breathing space for some of these zombies, but to what avail? We can’t post pone the inevitable.
You allude to not doing QE the way the government have proceeded on. I have some sympathy with this, i.e. , just cut to the chase and lend to business this new money. Well, for sure this would be better, but we would get some of these business some respite and if they did not correct and repair their balance sheets by re aligning their costs so that they could produce goods and services profitably so that consumers wanted to buy them, then hey, it has all been a waste of time. In the mean time, the new money created lowers the purchasing power of everybody, so once again, what is the point?
Much as we all want to “do something,” I can only see that business should pair back their costs, restore their profitability by taking our enough over head to make people want to buy goods and services with their higher cash balances, as being the quickest and least painful way of correcting the mess we are in. “Doing something,” like a QE operation to keep MV steady , even if lent to business by very , very astute and savvy central planners would just prolong the recession. The net result will be lower purchasing power for all as money debasement would have happened. But To, do remember in all of this, those people lucky enough to get the newly minted money first, as they exchange this for real goods and services, they are enriched , as prices go up, you and anyone else not in this chosen lucky ones, are impoverished.
I can think of no circumstances where QE could be advocated. Hayek may once in the preface to Prices and Production asserted this as a hypothetical OK in the most extreme of circumstances, but he certainly did not wax lyrical about this throughout 70 years of his career . If you look at the whole body of his work, he was no soft money many, but a hard money man.
You suggest something I find very odd indeed, our good friend George Selgin does say this as well…
“The old-fashioned Bagehot rule – providing liquidity support to solvent banks at a penalty rate – might well be preferable.”
Reflect for a moment. If you are solvent, your require no help. Thus the Bagehot rule on the face of it is meaningless. So does this really mean, “well if you were solvent before the crisis and you now look a little bit wonky, therefore , a shot in the arm from us the central bank will keep you going,” then I for one would prefer not the central bank to decide, but for those who command capital and have the entrepreneurial nouse to take control of this teetering / insolvent business and this is the role of the market and private capital.
If we are saying “look, yes, we know the market should be doing this, but we have this monstrosity called a central bank, then at least get it to do something as near as dam it to what the market would do, i.e. allocate capital to the most efficient users of it, then this is picking winers and losers via the state and I just have no faith, as for sure it is not a matter of reason, that this will ever be done well by even the most entrepreneurially smart central planner.
This all sounds very nice, but let me put a question to you.
Imagine you are the fed board in the depths of the 1930s great depression. Set aside questions of free banking for a moment, say we are operating within the constraints of the current central banking system.
What would you do? Would you sit back and watch the banking system destroy itself, and the money supply and economy along with it? Or would you attempt to resolve the problem through money printing? After Friedmans monetary history, it seems very difficult to me to argue that monetary intervention by the fed could not have lessened the severity of the great depression.
Good Morning Dan,
I assume a 1930’s situation today for the UK.
I would abolish corporation tax overnight. This would allow up to nearly 30% more free cash flow to remain in corporations allowing them to become less dependant on the banking system to make their own adjustments to their cost base to bring their cost base back into profitability. More companies in profitability and less in debt is the start of the recovery.
I would abolish all employment law and set a fixed tariff in its place based on time served for what ever reason a boss gets rid of you as these current costly and laborious tribunals only come down to a money argument at the end of the day. This will be fair, proportionate and allow the labour market to adjust.
I would unilaterally remove us from the common agricultural policy and the common fisheries policy and tell Europe, no more money. Thus reducing the burden of Europe on the British taxpayer, the farmer and the fisherman and thus all food prices . Food is still a large component of the UK taxpayers disposable income.
I would move to full reserve banking by fixing the money base as per Friedman or Huerta De Soto. This means no money deflation.
I would then set up the banking system in the fiduciary and non fiduciary split i.e. full reserve free banks and fractional reserve free banks as described above.
I would not engage in the policies of the witch doctor and mystic by doing QE as my one stop bet.
I could say much more, but does that give you a positive proactive flavour Dan?
OK, in terms of taking positive action to sort out a depression I see your point on moving to full reserve banking as being the most valid.
But your statement “this means no money deflation” I believe is not the case. Under a 100% reserve system, it would still be possible for banks to hold an excess of “free” cash and be either unable or unwilling to invest it, resulting in a reduction in broad money and deflation. In this case (taking the case of a government backed 100% reserve system), the volume of money would have to be increased to counter the deflation, which is effectively a QE strategy.
This point is made in “A Program for Monetary Reform” which was a proposal by several economists to repair the American Economy during the Great Depression.
There are many positives with a 100% reserve system, but I do not see it as being a cure for deflation (although it would allow for greater control of the money supply than under a fractional reserve system).
I don’t agree with you or Toby about 100% reserves.
However, Toby is right about this. In a 100% reserve system there is no “inside money”, or no fiduciary media. There is only “outside money” or base money. Any 100% reserve notes or balances that circulate are bailments for base money.
When a bank holds a quantity of money that it doesn’t lend out that means that the bank is holding base money. In a 100% reserve system the same is true if I hold a quantity of money too, no matter whether I hold it as base or as a balance in a 100% reserve account. There is no difference here between banks and other economic agents.
In a fractional reserve system it makes sense to classify things differently. In an FR system base money that’s kept by a bank is reserves. It may serve some purposes that are similar to those that normal holding serves. But, mostly it’s quite different, to the bank it’s an asset held to provide redemption to customers. 100% reserve banks don’t need an excess to provide redemption since for each £ of a customers balance they hold a £ of base money.
I’m not arguing that price deflation can’t happen under a 100% reserve standard, both price deflation and inflation certainly can happen as the demand for money changes. However, in such a system the demand for money or a bank is no different to that of any other agent such as an individual or business. Suppose I increase my base money holding and a bank increases it’s base money holding. In this case it could be said that the bank is causing monetary deflation, whereas I’m only causing price deflation. But that wouldn’t make any sense, our actions aren’t different in any categorical way.
I should mention too…
In a fiat 100% reserve system this doesn’t apply to the issuer of fiat currency. That institution is clearly different, any buffer stock of money they hold can’t be considered a normal money holding and included in monetary aggregates.
Rob, I thought you would totally be in agreement with my fiduciary non fiduciary banking split suggestion as it accommodates all free banking views.
Dan has been suggesting we think of an “in crisis” moment and setting up on free banks, both fiduciary (100% reserve) and non fiduciary (FR) would need to go though a 100% conversion at the point of meltdown I would suspect before you could lay the solid platform from which to build both types of banks ground up within a very strong legal framework of property rights and full contract disclosure.
I agree with some of the things you’ve said about it, but not all.
I agree with you that banks should be made to declare clearly that bank accounts are debt contracts. I also agree with you that the government should not provide deposit insurance.
I don’t agree with some of the things that you’ve sometimes said though. I don’t think that existing banks should be made to provide 100% reserve accounts. If there is a market for such accounts then it will arise by itself if consumers know what FR entails and are not insured from it’s risks.
I also don’t think that FR banking should be treated by the law differently to other debt contracts.
You say…”I don’t think that existing banks should be made to provide 100% reserve accounts. If there is a market for such accounts then it will arise by itself if consumers know what FR entails and are not insured from it’s risks.”
By declaring the correct status of the bank accounts as per the Carswell Bill and getting banks to let you choose, the question of do people want safe keeping accounts or do they not gets answered , as does , so they want FR accounts , yes or no at the same time., also do they want savings (timed) accounts. So I think we are in full agreement then.
You say…”I also don’t think that FR banking should be treated by the law differently to other debt contracts.” I agree as well with this, to be clear, free banks met work un-privilged with regards to the law and accounting rules.
So we must be in agreement here as well.
Rob, not sure I understand your argument here on the difference between 100% reserve and fractional reserve with respect to economic agents. In a fractional reserve system, if I hold cash, I am holding base money as cash is 100% backed. All a 100% reserve system involves is treating deposits in checking accounts the same way as we treat cash now.
One of the problems in the Great Depression was cash hoarding, i.e stuffing cash under the mattress because of deflation and bank failures, which compounded the deflationary problem.
I assume you know the money quantity equation:
Monetary deflation is a fall in M. If the price of goods falls (ie PT) then that’s price deflation, not monetary deflation. In a 100% reserve system monetary deflation can only be caused by the creators and destroyers of money – the government in a fiat standard and gold traders in a gold standard.
In my opinion a 100% reserve system would not work well because it doesn’t compensate for fluctuations in V (or in Austrian terms, fluctuations in the demand for money). That is “hoarding” can increase and decrease. But, that’s not a monetary deflation issue.
In a 100% reserve system banks are not special their money hoarding – or to use a less loaded word, holding – is just like anyone else’s.
Rob, you make a clear distinction between price deflation and monetary deflation. But in the medium term they are one and the same thing – just as “inflation is always and everywhere a monetary phenomenon”, so also deflation is always and everywhere a monetary phenomenon.
You say that in a 100% reserve system monetary deflation can only be caused by the creators and destroyers of money; there is no real difference here with a fractional reserve system. In the end the central bank can in most cases cause inflation or deflation if it wants to in our current system; the only exception being the liquidity trap we are in currently where the central bank loses much of its control. And even in this case, QE is a tool that can maintain the central banks’ control, if it is determined enough.
They aren’t the same thing. If I decide to increase my holding of money by £40 that is not the same as me destroying £40 of money. I still have the £40 and I can call on it at any time to pay for goods and services. On the demand side we have changes in holding or hoarding money, and on the supply side we have the creation and destruction of money. These are different things. Now, in the long-term any change in the price of money is irrelevant. But we’re concerned about the business cycle here aren’t we? That means we have to think about short-run and in the short-run this is very relevant.
I wrote an article about this a few months ago:
You told me above that you’re reading Friedman’s book on monetary stability. In his early work Friedman was against Free Banking, and he believed that velocity in the equation MV=PY was constant. He came up with a measure of money called M2 which when plugged into MV=PY gave a constant money velocity over many decades. But, in the 80s and 90s this relationship broke down. Examinations of the economic record of other countries and other times showed that V had never really been constant. Friedman accepted these criticisms towards the end of his life, just as he became more positive towards Free Banking.
In a 100% reserve system monetary changes can only be caused by creation and destruction of *outside* money. In a fractional reserve system it can also be caused by creation and destruction of fiduciary media – *inside* money.
In an FR system the demand for outside money of a bank must be considered a differently to that of other agents. That because to the bank outside money is something it needs for reserves and payments.
I’m glad you now agree with me about that ;)
Firstly, that is a good article and some interesting illustrations on money and its effects.
“They aren’t the same thing. If I decide to increase my holding of money by £40 that is not the same as me destroying £40 of money. I still have the £40 and I can call on it at any time to pay for goods and services.”
Maybe we are debating semantics, it all depends on your definition of destroying money. If you put your £40 under your mattress and decide not to spend it, you are taking £40 out of circulation and decreasing the money supply by that amount, until you spend it. This is exactly the same as the central bank selling a government bond – it is decreasing the money supply but can increase it again at any time as it is the issuer of currency. And yes, I agree with you about the relevance in the short run.
On your criticism of Freidman, you are right that the M2 relationship broke down. However, the problem with monetarism has always been the question ‘what is money?’ Friedman switched to making predictions using M1 for a while, which also didn’t work. The issue is that, due to the complexity of modern financial instruments, there is no one measure of the money supply which could be used as a target. However, Freidman’s views on money and inflation remain valid in my opinion. There is a wealth of empirical evidence to support this.
But, what is “circulation”? At any time all money is owned by somebody. When a transaction occurs it passes from the hands of one person to another That person may then keep it for a period of time until they spend it. All money at any time is being held or “hoarded”. If I earn £40 and spend it within an hour then I’ve hoarded that £40 for that hour. On the other hand, if I earn £40 and spend it next year then I’ve hoarded it for a year. In both cases the stored money will form part of my financial planning. So, there is no clear difference between “circulation” and “hoarding”. Of course, an arbitrary dividing line can be made. This is where velocity and demand for money come in. We can say that in a particular time a person receives a certain amount of money and pays out a certain amount.
I don’t think it really is. To a normal person or business there is a decision to be made about how much money to hold at any one time. There are many factors involved this, but they all share uncertainty as a common factor. If a person can achieve his or her desired money balance, then that person is in a position to go forward with their future plans. So, if I have £5000 of assets and I want to hold £1000 of those as money then once I have achieved that I can go forward with my other plans.
Suppose that in order to reduce hoarding a government were to set a cap on the amount of money that any individual could hold (and suppose this law is enforcible). Would this prevent a fall in GDP? Perhaps, at least in the very short run. The problem is that by preventing people from holding money the government will stimmy the future plans of some people. It will cause them to act more cautiously and force them to seek workarounds.
One of the confusing things about money is that it it’s easy to make both a “fallacy of composition” or a “fallacy of decomposition”. Friedman would give money demand as an example of the fallacy of composition. When people in general try to increase their money balances and the supply of money is fixed then prices and incomes must fall. It doesn’t follow from the fact that one person’s rise in money balances may be good for him that a collective rise will be good for everyone. But, as I emphasised above, the opposite view is equally wrong. Preventing a person from raising his money balance isn’t necessarily beneficial to the economy as a whole because of the consequences for him, and through him for the wider economy.
Of course, since money can be created and destroyed this problem isn’t a complete conundrum.
Rob, yes I agree that there is no clear dividing line. But I think it is instructive to go back to definitions of the money supply. Taking the case of physical cash, notes and coins in circulation are always counted as part of the broad money supply (M1 or M2). But notes and coins in bank vaults are not. So any ‘hoarding’ of physical cash is directly reducing the broad money supply using the accepted definitions. The reason is obvious – vault cash is not available to be spent, just as bank reserves are not available to be spent. Taking the thought experiment of an economy that purely uses bank notes (100% reserve!), if the economy as a whole was forced to put half of its cash in bank vaults for a period of time, there would be half as much circulating medium available and a corresponding deflation.
And your fallacy of composition sounds remarkable like the Keynesian paradox of thrift ;)
In Greece lots of people are taking out safety deposit boxes and putting cash in them, or depositing cash in banks as bailments. In this case the money continues to be counted in monetary aggregates.
Vault cash held by banks isn’t counted in monetary aggregates. This isn’t because it’s locked up in a vault though, it isn’t because it isn’t “available to be spent”. Lots of cash isn’t “available to be spent” over some time-frame.
Neither is it because it circulates very slowly, it circulates very fast because it’s withdrawn and lodged by bank customers frequently.
The reason it’s not counted is that in a fractional-reserve system that would be double counting. A customer’s bank balance is a form of money – it’s money-in-the-broader-sense. So, we count that without counting the fractional reserve that the bank use to support it. Only when the bank pay out cash to customers who have requested it does it become part of the monetary aggregates. In that case there is no change in the overall aggregate because bank balances fall by the same amount that cash balances rise by.
I agree with you about that. But, it still doesn’t mean that monetary deflation and price deflation are the same thing.
Taking your example above… You are imagining a confiscation of money of some type. Now, there can be two types of confiscation, one where the public get their money back and another where they don’t. Think about the influence of expectations in this scenario. If the public believe they’ll get their money back the next day then prices will barely budge. On the other hand, if they believe that they’ll never get their money back then prices will drop very quickly. If the confiscation was expected beforehand then the situation would be different again.
You’re not considering the details of the transition (I mention this in the “Money is barren…” article I linked to above). To get anywhere with the quantity theory you need a theory of money demand and a theory of expectations.
The paradox of thrift is something different. There are things written about the paradox of thrift that don’t really make that much sense. The most defensible view of it though is that there can occur a rise in demand for safe assets, that can mean that people put more in bank accounts raising the amount of savings (the supply of savings). Then it’s supposed that it isn’t necessarily possible for entrepreneurs to translate this rise in the supply of savings into greater investment. Over some period of time I think this is true.
But, this isn’t what I’m talking about. I’m talking about the demand for money holdings. I’m talking about someone who want’s to keep their total assets fixed, but who wants to hold more or less of that total wealth in the form of money. I think this problem is more important, and more soluble.
“The reason it’s not counted is that in a fractional-reserve system that would be double counting. A customer’s bank balance is a form of money – it’s money-in-the-broader-sense. So, we count that without counting the fractional reserve that the bank use to support it. Only when the bank pay out cash to customers who have requested it does it become part of the monetary aggregates. In that case there is no change in the overall aggregate because bank balances fall by the same amount that cash balances rise by.”
Having thought about it, you are absolutely right on this – I hadn’t taken into account the double counting aspect.
Dan, far less money deflation then!
Toby, but if there is still potential for deflation in the case of 100% reserve banking, then surely there is also a need for money printing in a crisis to ensure a deflationary spiral does not take hold? Deflation because of a contraction in the money supply was the principal cause of the prolongation of the Great Depression.
What you seem to be saying here is that demand for money tracks the price level that consumers desire. So, if consumers think prices are too high they hold more money.
Does this mean, correspondingly, that if the demand for money falls then that means consumers think prices are too low?
Rob, as I said, I hold more money as am I scared about the economy – never more so than now. I speak for my self. I do notice this with others. If things were cheaper , especially houses and businesses , then yes, I think we would have more spending.
Yes, wouldn’t it be great for those of us with a few bob if assets were cheaper? I couldn’t agree more. If houses and businesses were cheaper then I would be able to invest in them and get a higher return. That would be excellent for me ;) and, I expect, excellent for you. But, this doesn’t mean it’s a good macroeconomic policy.
To go back to the earlier point, I don’t think that demand for money is related to what prices consumers think are reasonable. Certainly if money holding increases then prices fall, but that doesn’t mean that consumers are trying to make prices fall be increase money holdings. Consumers don’t decide as a block what to buy and what to boycott, it’s an individual issue. To each agent, even very large companies, the purchasing power of money is something that is imposed on them.
However, I agree entirely that during periods of uncertainty people refrain from spending. Your concern about the economic situation at present time is held by many, and many will respond in the same way.
That doesn’t mean though that falls in asset values are necessarily a good thing. You’re thinking of the issue purely from the point of view of someone who holds low-risk assets (including money) and it thinking of buying higher-risk assets. The issue is reversed for those who own those assets. The current owners of the housing and businesses that you think are too highly valued would loose out if prices of those things were to fall further. But, these sorts of redistributions are not of great concern to us in considering the business cycle.
What should concern us is the capability of the future economy to provide goods and services. That capability is, in the long-term, always assisted by forms of capitalist saving such as holding bank balances.
The concerns that Austrians have had about ABCT is that during the boom the prevailing low interest rates increase the level of roundaboutness and capital intensity to an unsustainable degree. Then if saving decreases when the boom ends then interest rate will rise and these projects will be unsustainable. This doesn’t apply if saving doesn’t decrease and natural interest rates doesn’t rise.
Great replies Toby. I just worry about the Adam Smith Institute. At the Hayek debate I spoke to many people and there were mutterings of the ASI being co-opted by the political centre. I don’t recall hearing ‘Austrian School Economics’ or Mises mentioned in interviews as if its frightened to tell the truth. I often find it difficult to make out where they stand. Anyway they are missing out on many enrolling possibilities for people new to/previously bored by mainstream ‘astrologer’ economics.
Good morning abolishincometax,
The truth that the only way we can pay for all this past vast credit creation monster is a painful cost reduction down to restore profitability and it is not a popular message hence no politician will advocate it. There is a small chance it may be taken out of their hands by Sovereign debt defaults all over the world . The inverted pyramid of debt they are all trying to blow air into will eventually fall. It may be a spectacular collapse, or a slow default over many years if not a decade or two via inflation / debasement.
The messenger of doom always get shot! But my message of doom is always parcelled up with a message of great hope based on my firm belief that the entrepreneurs of this economy, if left to their own devices via there undeniable human enginuity will get their costs into line, will produce goods and services people want as and when they want them and in the volumes they want them. Thus the seeds of the recovery will be sowed .
Above all, what Hayek and the Austrian School teaches us is how not to get into this mess in the first place. Flirting with second best solutions, last ditch roll of the dice options, like trying to get the BoE to approximate what free banks may or may not do is unwise . I would be disappointed is for the sake of political expediancy the ASI were flirting with second best policy options when in the past they have been resolutly for the free market.
“Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.”
Hayek, Prices and Production:
“..in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.”
So, stabilization of MV according Hayek is impossible as a maxim of monetary policy, and your entire post is based on a false premise taken from White’s fallacious interpretation of Hayek.
Neither Mises nor Hayek were consistent advocates of either free banking or monetary disequilibrium theory.
In “The Theory of Money and Credit” Mises uses monetary disequilibrium theory everywhere, but the proposals for reform he ends with favour 100% reserve banking.
Hayek doesn’t push MV targeting at all strongly in his earlier work. He pushes it briefly in “The Consitution of Liberty” and then shifts to supporting free banking in his later work.
And even better:
“In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning;: (Hayek)
How then Hayek could prescribe anything about MV when he did not believe that averages could have ever formed a link in a legitimate scientific reasoning?
Nikolaj, I had a Professor tell me that there was a “Hayek Rule,” and more to the point that this was established and understood. This rule is that money should be accomodative when velocity changes . Like you , I could dig up quotes and whole books of Hayek that would say this may be a case in theory but can never be achieved in practice. On a separate matter, I have read all the Hayek quotes that Larry White digs up (that Tom Clougherty brings up in his article on this site) and read them in the context of Hayek’s work and conclude the view that I have always held since I have been reading Hayek as a 16 year old, he would baulk at any suggestions of a “Hayek Rule,” or that his money policy view in life would be to control MV. I think this is very poor scholarship to suggest this without inserting many caveats and making all readers aware of the mountain of words from Hayek himself contradicting these selected quotes. The Modern Fractional Reserve Free Banking School have theory and it is well thought out, but to link Hayek in as a advocator I think is a suggestion too far. It stands on its own two feet and does not need to hang on Hayek for its legitimacy and I am sure Hayek , on my reading, on this point, would not endorse it.
Now Nikolaj, you and I both know that I don’t have to resort to “aggregates acting on each other” in order to justify monetary disequilibrium theory. I’ve got an article in the works about that.
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