Most experts are of the view that still-subdued economic activity requires a more aggressive stance from policy makers in order to revive the economy. Since the end of 2007 the Federal Reserve pumped about $2 trillion into the banking system while the US central bank policy rate – the federal funds rate target – was lowered from 4.25% in December 2007 to 0.25% at present.
A week ago US President Obama suggested a $450 billion stimulus package to revive the economy. Observe that in February 2009 the Congress had approved Obama’s first stimulus package of $787 billion. Despite all the aggressive measures taken by the Fed and the US government the economy remains depressed. Since the approval of the first fiscal stimulus package almost 2 million jobs were lost. While since the end of December 2007, when the aggressive pumping by the Fed was introduced, almost 7 million jobs have disappeared. The unemployment rate has jumped from 5% in December 2007 to 9.1% in August this year.
Why then should Obama’s additional fiscal stimulus package and more aggressive Fed pumping revive the economy? The experts are of the view that given the lack of positive response by the US economy to all the fiscal and monetary stimulatory policies, it implies that the economy has strongly deviated from the path of balanced economic growth. On this way of thinking the economy is seen as some kind of space ship that has deviated from its trajectory. To bring it back onto the correct path policy makers must give it an external push. So if the first push in terms of loose monetary and fiscal policies didn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the correct growth path.
Loose policies can only damage not strengthen the economy
The purpose of production is to generate final consumer goods and services that maintain and improve individuals’ life and well being. Various means are employed for this such as tools and machinery and labor. All these resources whilst important are not sufficient.
What is required is an adequate pool of final consumer goods and services that will maintain the life and well beings of individuals engaged in various stages of production that range from the production of final consumer goods and services to the production of tools and machinery i.e. capital goods. It is the pool of final consumer goods and services that funds various activities. The size of this pool dictates the type of activities that can be undertaken.
For instance, if the size of the pool permits the building of a very basic tool then the building of more advanced machinery cannot be undertaken, notwithstanding the plentiful of natural resources, technological knowhow and skilled labor.
In order to be able to make more advanced machinery individuals, instead of consuming existent produced final goods, would have to save a portion of these goods and allocate them towards the enhancement and the expansion of tools and machinery. With better tools i.e. capital goods, a greater production of final consumer goods can be undertaken, which in turn will permit the making of a more sophisticated infrastructure.
Note that any form of economic activity must be funded by means of final consumer goods and services. Neither the government nor the Fed have the ability to generate final consumer goods to fund the building and the enhancement of infrastructure.
For instance when the Fed pushes more money to the economy all it is doing is increasing the amount of the means of exchange. An increase in money supply sets in motion an exchange of nothing for something i.e. it diverts final consumer goods or wealth from wealth generating activities towards non-wealth generating activities. This in turn undermines rather than strengthens the economy’s ability to expand real wealth. (It is exactly the same outcome produced by a counterfeiter).
Likewise loose fiscal policies produce the same results as printing money does – it diverts wealth from wealth generators to non-wealth generating projects. What then is the point of trying to boost employment by means of loose fiscal policies, which in the process weakens the economy’s ability to generate more wealth (such as digging ditches and making pyramids)?
Once the central bank tightens its stance for whatever reasons the diversion of wealth to non-productive activities stops and various useless projects must be aborted. Obviously various individuals employed in these projects become unemployed.
It is true that now we have idle resources. Contrary to popular thinking the employment of idle resources with the help of loose policies is not cost-free, this requires the diversion of wealth from wealth generating activities.
Also, it is false that loose fiscal and monetary policies are required to fix the unemployment and revive the economy.
Remember that loose policies only weaken the ability to generate wealth. Obviously then we require less and not more of these policies to grow the economy.
A better alternative is to curtail the ability of the Fed and the government to engage in aggressive loose policies. This will leave more wealth in the hands of wealth generators and will enable them to get on with the job of setting in motion true economic growth.
With the expansion in the production of wealth, all other things being equal, a greater demand for resources including labor will ensue. In short more wealth will make it easier to absorb so called idle resources.
Despite aggressive fiscal and monetary policies the US economy remains subdued. Since December 2007 almost 7 million jobs have disappeared. Experts, however, are of the view that a more aggressive monetary and fiscal stance is required to revive the US economy. We suggest that loose monetary and fiscal stance will only further damage the foundations of the economy.
Fiscal and monetary policies do give the economy a push, but not from behind. They push from the side which explains why things are spinning out of control.
Dr Shostak’s views appear to represent the mainstream Austrian view that the current “great recession” was caused bu past inflationary booms that led to major distortions in the structure of production. The reason that we now have idle resources is directly related to those distortions – bad investments from the past need to be liquidated and more appropriate structures recreated from scratch and that takes time.
This argument has much validity. However I think it fails to recognize the possibility of what Hayek called “secondary deflation”. Following a bust not only do we have mal-investements that need to be liquidated but we have an increase in the demand for money that, in a world where prices take time to adjust to changes , will inevitably lead to an additional slowdown in economic activity.
In a free market a mechanism would exists to deal with this scenario. Free Banks (who as a result of the increased demand for money would experience an increase in cash balances) have the incentive to expand the money supply to accommodate the increased demand and prevent the “secondary deflation” from having serious consequences.
No such mechanism exists under a central banking system where monetary policy is at the whim of a government appointed functionary. The normal tendency is for central banks to over-inflate (in which case every thing that Dr Shostak says is true). However lacking the profit signals that free banks have central banks can get it wrong the other way and worsen the deflation by failing to address a high demand for money.
There is much evidence that this is what is happening right now. Obviously the real answer is a free market and free banks. Central banking caused the bust and is failing to address the recession. But nevertheless to ignore the monetary aspects of the current situation is also incorrect.
I agree with you.
I’m not sure Frank Shostak’s view represents that of the majority of Austrian Economists either. It certainly represents the majority of those who write articles for the internet and for the LvMI, but I doubt Austrian Economists at other universities would agree.
Frank is working in the tradition of Bohm Bawerk and his substance fund , within the tradition of Mises, Hayek and Rothbard, thus this is the vast majority of what people would call the Austrian School. Your MET friends are a small offshoot of the Austrian School who find much more in common with the American Dis-equilibrium Theorists .To say Frank is in a minority view on this shows a uncharacteristic level of ignorance by you. A very poor comment Rob.
Well, I’m not arguing with Frank or you on the subsistence fund. That’s generally accepted in one form or another. (And as I mention below it’s accepted in a hidden way by modern Keynesians too when it fits their argument).
I can’t place the arguments of the 100% reserve camp outside the Austrian school. Mises and Rothbard both clearly supported 100% reserves. But I don’t think you can say that monetary disequilbrium theory is an “offshoot” of the Austrian school. The positions of Hayek and Ropke are similar to modern monetary disequilibrium theory. Mises theoretical position is similar even if his view of the practical outcomes for fractional reserve banking is different.
I am delighted you know what Hayek thought and you place him at the heart of disequilibrium theory.
Lets see what he said ….
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.”
And from Denationalisation of Money by Hayek
“‘Neutral money’ fictitious
My impression is that economists have become somewhat over-ambitious concerning the degree of stability that is either achievable or even desirable under any conceivable economic order, and that they have unfortunately encouraged political demands concerning the certainty of employment at a hoped- for wage which in the long run no government can satisfy. That perfect matching or correspondence of the individual plans, which the theoretical model of a perfect market equilibrium derives on the assumption that the money required to make indirect exchange possible has no influence on relative prices, is a wholly fictitious picture to which nothing in the real world can ever correspond. Although I have myself given currency to the expression ‘neutral money’ (which, as I discovered later, I had unconsciously borrowed from Wicksell), it was intended to describe this almost universally made assumption of theoreticalanalysis and to raise the question whether any real money could ever possess this property, and not as a model to be aimed at by monetary policy.1 I have long since come to the conclusion that no real money can ever be neutral inthis sense, and that we must be content with a system that rapidly corrects the inevitable errors. The nearest approach to such a condition which we can hope to achieve would appear to me to be one in which the average prices of the ‘original factors of production’ were kept constant. But as the average price of land and labour is hardly something for which we can find a statistical measure, the nearest practicable approximation would seem to be precisely that stability of raw material and perhaps other wholesale prices which we couldhope com- petitively issued currencies would secure.
I will readily admit that such a provisional solution (on which the experimentation of competition might gradually improve), though giving us an infinitely better money and much more general economic stability than we have ever had, leaves open various questions to which I have no ready answer. But it seems to meet the most urgent needs much better than any prospects that seemed to exist while one did notcontem- plate the abolition ofthe monopoly ofthe issue ofmoney and the freeadmission of competition into the business of providing currency.”
When demand changes and people hold larger cash balances are they saying in effect, “we are not prepared to pay the current higher prices for these goods and services offered by the market and when we are comfortable that they are correctly priced and what we want, we will send again,” or something else?
Unlike you, I am quite confident at best, you can say Hayek moved from advocating to emphatically denying the approach of the America Dis -equilibrium School. Thus confused on the matter , thus best to leave him out of any debate on the issue.
The genius of Selgin (laying out the theory) and White (laying the foundations of the theory and giving it a historic setting) and now Horwitz (especially the latter) is that they have taken key Austrian Insights on methodology and capital theory and crafted it onto the Dis-equilibrium theory that does not sit within the Austrian School, but takes alot from it. I really think you will find they will agree with that, that is also why they do not say they are Austrian School economists. They may disagree on how strong Hayek was or was not on this.
I don’t think my position is very different from Hayek’s in either of these two pieces.
“Neutral Money” has always been something of an insult. Keynesian textbooks throw the idea at the “Classical Economists”, claiming that they believed money had no effect on exchange relations. But, many of the classical economists didn’t believe money was neutral.
In some of Hayek’s early works there is a “neutral amount of money”. That means that it’s assumed at some time that the current amount of money isn’t causing real effects, though that may change at future times. Despite what some critics say even in Hayek’s early works money isn’t “neutral” in the sense the classical economists meant.
I agree that no creation of money of any sort can be neutral to relative prices. In that sense money is like every other good, since creation or destruction of other goods is never neutral to relative prices either. But, I don’t think that this negates the idea of monetary equilibrium. Yes, when money is created and spent that has distributional effects, but so does every other market process.
Hayek isn’t been inconsistent just as he isn’t inconsistent when he agrees with free-markets despite disagreeing with perfect-markets models.
I don’t think demand to hold cash balances is closely related to value-for-money.
Let’s suppose that I’m of the opinion that I’m not getting good value from my purchases of consumer goods. In that case I may hold assets instead, including financial assets such as money. Now, if I believed that other assets were also poor value then I could hold money instead. In that case I believe money offers the best value.
The problem here is that other assets almost always give higher yields than holding money. Even in the current recession it’s not at all difficult to find bonds that pay a few percent interest, which is better than most current accounts and savings accounts. Objectively other assets give better value than money.
Money is useful though because it can be readily spent at any time, it is the medium-of-exchange and has no maturity date. That’s why we have the “speculative” and “precautionary” motivations to hold money, which are really very similar. In both cases a person is holding money in order to be able to do something whenever they need to, rather than having to plan their actions in advance. Both motivations concern uncertainty and uncertainty is always the reason for holding money.
If there were no uncertainty in life we could hold all our wealth in other assets because we’d know when exactly in the future we would need to make a purchase. For example, in a world without uncertainty I may know that my car will need replacing on 23rd Jan 2014. So, I can have a bond which matures on that date to pay for a new car. We need money because real life is full of uncertainty.
In a free-banking system when the demand for money rises banks have every right to create more money. They have legitimately obtained their reserves by supplying banking services. I agree that this is much less clear in the current situation where commercial banks are protected by central banks and depositors by deposit insurance.
You can’t support a banking system when it can create new money (new purchasing power) , just because some people which to hold more cash on demand . Why , because we need some solid bedrocks in society on which to build peaceful exchange. One of these is a money unit that you can rely on for a store of value. Remove a banks ability to have your money in one place , owed to you and in another series of places and you have honest money. Absent that and the money is dishonest.
Hayek also supported 100% reserves at various parts of his career .
Morning Rob R,
We have a central bank that has put so much extra reserves into the system and no lending. The theory of fractional reserve banking (FRFB) says what you say in a nutshell. It was never advocated by Mises and Hayek went backwards and forwards with it. His last know writings on it called “Neutral money fictions” in page 87 of Denationalisation of Money 3rd edition IEA shows that he thought this FRFB adjustment was a fiction and could not be achieved. I agree with him and of course Mises who denied this all his working life. In the 1st Edition of the Theory of Money and Credit, Mises has a whole section of money dis-equilibrium theory , it was never reproduced in all other editions that he supervised this suggests he rejected it in its totality , indeed he never discussed it thereafter .
When people demand to hold more money in the form of a cash balance, as they do today, they do not want to spend as they used to. They hold as a precaution . If a FRFB then starts to recycle this money to new loanable funds to business who are cash starved , as their customers do not want to buy their over priced products anymore, then the lending of this recycled money would be pointless and achieve nothing as they consumer is not going to spend as they did before.
FRFB is an elegant theory , but it lacks any practical relevance in this respect. When you have millions of consumers holding large cash balances not wanting the goods offered, the ONLY FREE MARKET response is to let prices adjust to something that will clear this situation . We are very much in a secondary deflation, well really it is still the unwinding of the first and it still goes on because the free market is not allowed to meet the new expectations of consumers and clear.
Mises uses Monetary Dis-equilibrium theory in all of the editions of “The Theory of Money and Credit” and he uses it throughout the book too, not just in one particular section. He uses it is “Human Action” too.
From the third edition of “Human Action” first published in 1963:
Where Mises differs from us modern monetary disequilibrium economists is in opinions on the size of effects and on policy. As far as I can see Mises didn’t see changes in the demand for money being important outside of recessions caused by ABCT, and he saw changes in supply as being important only because they could cause ABCT. So, he saw 100% reserve banking as a wise policy to shift to in a world where Central Banking is established.
Rob, this is not money dis equilibrium theory , this is just a basic demand and supply application to money as per any other good. The advocacy of changes in money to keep prices stable is entirely another matter which is money dis equilibrium theory . This is discussed in detail in the 1st Edition and dropped from all others . It’s dropped as he did not believe in it .
What I’m talking about here is economic ideas not policy prescriptions.
I suppose your comment shows how similar our view are.
To most schools of economics supply and demand for money either doesn’t exist or isn’t relevant. In the original formulations of Monetarism money velocity was held to be fixed, that’s the same as say the demand for money is fixed. Quasi-monetarism has money demand but very little theory of how money is injected/supplied or withdrawn from circulation. Old Keynesianism doesn’t really have money demand, it has demand and supply for saving which isn’t quite the same thing. New Keynesianism treats money a bit differently, but it still doesn’t really use supply and demand.
When economists talk about “monetary disequilibrium theory” they generally mean theories where there is supply and demand for money and a process by which supply and demand operate. It’s also generally understood that disequilibrium occurs because prices take time to change, and injections of money have special effects. On those subjects Mises opinion is very close to mine and to those of Larry White, Steve Horwitz and George Selgin. Which isn’t surprising since Mises is one of the people we’re drawing on.
In terms of policy Mises disagreed with us in many of his works, he advocated monetary policies that would strictly limit the supply money (sometimes he advocated a 100% gold standard, sometimes something slightly different). So, he didn’t advocate the same monetary policy that the FRFBers do. It seems to me that he saw the risk of monetary expansion as being large and the problems of non-satisfaction of money demand to be small. So, within a central banking system he advocated a return to the gold standard initially followed by a return to free banking later.
“However lacking the profit signals that free banks have central banks can get it wrong the other way and worsen the deflation by failing to address a high demand for money.”
Take care Rob R The Weimar Republic were quite convinced that they were responding to the publics demand when they were printing bucketloads of money.
Best is to let the value of money increase.There may be a lag effect but I doubt it and the spectre presented of the scarcity of money causing a depression is rather more far fetched than the spectre of wild money printing by Central Banks becoming a large part of the problem.
Inflation in the Weimar republic was caused by an extreme lack of demand to hold money – but I take your point. Calling on the central bank to print more money is like criticizing the devil for his failure to increase sin.
However in a world where we have price rigidity and high demand for money to simply say that everything is down to structural distortions due to the last boom is going to cause free market views to lose credibility.
“It is the pool of final consumer goods and services that funds various activities.” The word “fund” normally means something like “supply cash”. So how exactly does my possession of a three piece suite, a stock of booze and a fridge freezer supply the cash for “various activities”? I’m baffled.
“The size of this pool dictates the type of activities that can be undertaken.” So if I have two three piece suits and a bigger stock of booze, etc that alters the type of activities….. (whatever these mysterious activities are) I’m still baffled.
“For instance, if the size of the pool permits the building of a very basic tool then the building of more advanced machinery cannot be undertaken.” I don’t see how possessing a three piece suite helps me make a simple tool like a radio. Owning some DIY equipment including some soldering gear would be more help. But then Shostak says that if I have the equipment to make a “very basic” radio (to quote), that means I cannot produce a “more advanced” radio (to quote). I’m still baffled. But I’m always keen to be enlightened.
Money only facilitates the exchange of goods and services for other goods and services, you may be better off looking at the economy via this lens , then you realise that you need saved goods to produce more goods and services etc. This is the simple message that gets lots when economists start to think of money as wealth and not goods and services and your command over them.
I think Dr Shostak means that you need to be producing (or have stored) enough consumer goods to also sustain those who are producing capital goods.
If you adopt a structure of production that does not generate enough consumer goods to sustain everyone in the economy once the current stock has been used up then the new structure will prove to be non-viable. For example if a group of farmers who currently use only shovels decide to devote all their resoirces to building a tractor they will run out of food (unless they have sufficient stored) before the tractor is finished and they will likely have to abandon the project and go back to basic farming.
Ralph, Rob R,
Think about the concept of “aggregate supply” in Keynesian economics.
Does it mean all capital that exists? No it doesn’t. What does it mean then? Really what it means is that within some time period there is the capital to produce a certain amount of output of finished goods. That capital consists of two parts, a “subsistence fund” of consumer goods and a stock of capital goods and inputs that are used to make the outputs.
Keynesians agree with this kind of logic when it suits them.
Morning Rob R,
This is the correct view of what Dr Shostak is saying.
Good Afternoon Toby,
Thanks for your detailed reply to my post.
Just to be a bit controversial – as this link shows Mises was not so unambiguously pro 100-reserves as is often supposed:
However Free Banking theory has to be accepted by its ability to map to reality and not by its sponsorship by Mises/Hayek or whoever. I accept that the theory is undeveloped in some areas. I hope we both live long enough to see a free banking world where FRRB (where all depositors are willing participants) and 100-reserve banks compete against each other and we will see which theory holds up better in practice.
I would like to attempt to address the main issues you raise about credit expansion in the face of a changed demand for cash holdings:
“When people demand to hold more money in the form of a cash balance, as they do today, they do not want to spend as they used to. They hold as a precaution . If a FRFB then starts to recycle this money to new loanable funds to business who are cash starved , as their customers do not want to buy their over priced products anymore, then the lending of this recycled money would be pointless and achieve nothing as they consumer is not going to spend as they did before.”
In regards to the changes in the demand structure itself: Whether the changed money demand is addressed by expanding the money supply or only by adjusting prices it will result in a change in the structure of production to reflect the new demand schedule. In both cases whether particular businesses which are adversely affected by a falling demand for their product survive or not will depend upon their ability to adapt to the new situation including the ability to attract new investment . They will only succeed in doing this if they are able (or are expected to be able) to provide the highest available return to new investors. Under both banking systems only those businesses will survive that are best able to meet the needs of consumers after the change in money and other demand schedules.
In regards to the holding of cash balances as a precaution: In a free banking world individuals can choose whether to hold these precautionary reserves either in commodity money in 100% reserve banks , or as cash balances in FRFB’s. If they choose the latter option then the banks will be able to use the funds to increase the money supply either by making loans directly or (and this is more likely in a time of high perceived risk) in other assets such as bonds. The effect of this expansion of the money supply will not be to exactly replicate the demand structure from before but rather to allow production to the new schedule to adjust without the added complexity of dealing with a generalized rise in the value of money.
Good Evening Rob R,
“I hope we both live long enough to see a free banking world where FRRB (where all depositors are willing participants) and 100-reserve banks compete against each other and we will see which theory holds up better in practice.”
I agree in full with that.
“In regards to the holding of cash balances as a precaution: In a free banking world individuals can choose whether to hold these precautionary reserves either in commodity money in 100% reserve banks , or as cash balances in FRFB’s. If they choose the latter option then the banks will be able to use the funds to increase the money supply either by making loans directly or (and this is more likely in a time of high perceived risk) in other assets such as bonds. The effect of this expansion of the money supply will not be to exactly replicate the demand structure from before but rather to allow production to the new schedule to adjust without the added complexity of dealing with a generalized rise in the value of money.”
This, I agree with the sentiment and say you are on the right track…. however, I would say the base money at least should be fixed ( my ideal model is 100% fix, but would have what follows as a fall back position) , this way, the money supply would not grow in the terms that we have today, but cash balances would move into loans and visa versa. Thus precautionary holders could sit in a 100% reserved environment and their cash balance will not be intermediated , thus their time preferences will still remain aligned to not being lent to produce more goods and services for future consumption , and the ones who want their cash balances could have their money mediated out to loans, thus their time preferences would be aligned to supporting the production of more goods and services that they will eventually spend this money on.
I think neglect on this matter is a weakness in the current versions of FRFB and if addressed would give much more robustness to the Theory of Free Banking .
This is something I have consistently said on this site.
Thank you for joining the debate.
All viable models for Free Banking that I am aware of assume that base money will be fixed (and would very likely be a commodity money such as gold). FRFBs would lend out money in excess of these base money reserves but only to the extent that this keeps the quantity of money used for transactions (as opposed to being held in cash balances) constant and never in excess of the quantity of base money.
Yes, this system as described will be boom bust inducing for sure for the reasons mentioned above , precautionary holders for as start will have their money intermediates like it or not as there is no ability for these banks to offer safe keeping , that a precautionary holder in effect wants . Odd suggestions of putting money in shoe boxes or safe deposit boxes and removing your self entirely from the payments system is a none starter , that is why it is not done. This un balancing of time preference caused by the FRFB’s must be boom bust inducing . Correct that and you might have a system that is more theoretically coherent and an ability to get the heirs to Menger etc to unit around a truly coherent non boom and bust free banking solution .
What you’re saying here is more reasonable than what you’ve said elsewhere in this thread and I agree with you to some extent.
Mises classes “saving” into two types. There is “plain saving” which is storing things. That could be a store of commodity money, consumer goods or unused capital goods. The other sort of saving is “capitalist saving”. In that situation a person makes a loan, they exchange money in the present for an agreement to supply money later. Bonds and savings accounts are savings of this sort. Holding fiduciary media is also a saving of this sort.
As is frequently pointed out around here lots of people are confused about the nature of their bank accounts. Some believe they’re engaging in plain saving where in fact their engaging in capitalist saving.
Does that cause a problem? Well, let’s suppose for a moment that everyone knew. In that case I don’t think their behaviour would change much because state-supported deposit insurance means that they don’t have to care about the stability of the bank they use. However, if deposit insurance were abolished and at the same time some bank customers still didn’t know that they’re accounts are not plain saving then that would cause problems. Those people would be taking risks that they don’t want to take. If that situation were rectified then risk would be reduced.
I doubt though that many people would take up the opportunity to use 100% reserve accounts. That sort of banking wasn’t popular in the past eras of free banking, I don’t see why it should become popular now.
I don’t agree that by saving people are refusing to pay for “overpriced” goods. Though it makes sense to save if you think prices will go down in the future. That’s Keynes’ liquidity trap. In a 100% reserve system if there is a rise in the demand for money then prices fall. But, that doesn’t mean that those who hold money want price fall.
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