Saturday, January 7, 2012

Economist Magazine on Macroeconomic Alternatives

The Economist magazine has condescended to looking outside the economic mainstream box when it comes to economic policy, even to discussing Austrian economics. Unfortunately, this most realistic of all bodies of economic thought gets lumped together with some rather suspect theoretical frameworks. Much ink is given to so-called "modern monetary theory," the advocates of which advise the government merely print up as many dollars as it takes to cover our debt. That figure is now above $15 trillion (with a T)? That is, as they say, a recipe for rather bracing price inflation.

The writer devotes even more words to the new monetary fad on the block: nominal GDP (NGDP) targeting. NGDP targeting is being pushed by Bentley University professor Scott Sumner. His suggestion is for the Federal Reserve to adopt a new policy rule: instead of targeting a rate of growth in the money supply or prices or interest rates, the Fed should aim to maintain a certain level or rate of growth in NGDP.

As the Economist reports,
Central banks set targets to make their currencies credible and their policies predictable. The target for many is to keep consumer prices growing at 2% a year or thereabouts. For the past few decades that has largely succeeded in stabilising inflation; but in the current crisis it has singularly failed to stabilise the economy. In America NGDP plunged over 11% below its pre-crisis path and remains there; what people buy at the prices they pay for it is much less than most would want.
However, this begs the really important question. Why did NGDP plunge to begin with? Why does the Fed need to stabilize at all? If the secret to economic coordination is stable NGDP or a stable rate of growth in NGDP, why did things collapse in the first place

In order to properly consider such questions, it is imperative to have a good understanding of economic activity. All economic phenomena is the result of human beings applying scarce means to achieve theirs ends. The fundamental problem of scarcity cannot be eliminated by central bankers creating more monetary units. Those who advocate targeting some level of NGDP need to explain why society would be more prosperous if there are more monetary units.

In fact we know that increases in the money supply--even those thought necessary to achieve some target level of aggregate expenditure--do not provide a general social benefit. At best monetary inflation merely results in higher prices for the same amount of goods. Increasing the money supply via credit expansion, however, does redistribute wealth to those who receive the newly created money first and away from those we receive the new money later or not at all. Such artificial credit expansion also results in artificially low interest rates, leading unsustainable inflationary booms that necessarily must result in a recession

Additionally, what can the Economist be talking about when it says "what people buy at the prices they pay for it is much less than most would want?" This is only true from the perspective of the businessman. Consumers prefer to buy at lower prices. Ask those who shop at Wal-Mart. It also presupposes that markets do not equilibrate via price adjustments. This is an heroic assumption. Readers of this blog, for example, are well away that so-called "sticky wages" may not be that sticky after all.


  1. What if we abolished the central bank and adopted the free banking model of George Selgin, in which supply and demand of outside currency (with a frozen monetary base) is governed purely by market forces of supply and demand? Would you then still be opposed to more monetary units being created? (Selgin's theory demonstrates how such free banking systems automatically stabilize NGDP.)

  2. My comment above should read "Would you then still be opposed to more monetary units being created in response to an excess of demand for money?" (The increase in demand for money relative to supply is what caused the drop in NGDP.)

  3. Yes. While it is probable that a free banking system without central banking would be less inflationary and, hence, result in less economic distortion than our current system, commercial banks that create and lend out monetary units are still making loans not funded by voluntary saving.

    Commercial banks that create fiduciary money with such loans still set in motion malinvestment of capital. Creating fiduciary monetary units might help stabilize NGDP, but it destabilizes rather than stabilizes the social economy. On top of that is the ethical and legal problem of creating more than one legal claim to the same piece of property.

  4. But wouldn't the elimination of monetary disequilibrium (and thereby stabilizing NGDP) through free banking help stabilize the social economy by eliminating cyclical unemployment and decreasing uncertainty related to investment? It's not obvious to me why creating fiduciary monetary units in response to an increase in demand for them causes more instability than, say, increasing t-shirt production in response to an increase in demand.

  5. In the first place, an excess demand for real cash balances cannot be offset merely by increasing the nominal money supply, because the additional money will reduce the purchasing power of money relative to what it would otherwise be, which reduces real cash balances. This would exacerbate the situation and most likely result in a further increase in money demand. Issuing more fiduciary money, therefore, actually works contrary to the preferences of those who desire increased real cash balances.

    Additionally, an increase in the demand for money need not result in persistent monetary disequilibrium and certainly does not necessarily result in a contraction and cyclical unemployment. It is possible for an increase in demand for money to be anticipated like that for any other good. As with other goods, those entrepreneurs who more correctly anticipate such increases in money demand relative to supply will act in such a way as to maintain profitability. At any point in time, an entrepreneur can protect himself against a drop in prices resulting from an increase in the relative demand for money by either bidding down present factor prices or by abstaining from investment.

    To more directly answer your specific question, the reason issuing fiduciary money is worse than increasing t-shirt production is that, obtaining money in the present by selling a t-shirt in the present does not direct capital investment toward projects that are unsustainable. Such a transaction is contrary to neither the preferences of the immediate traders involved nor social time preferences.

    Issuing fiduciary money via credit expansion, however, promotes unsustainable boom activity because it provides an incentive for entrepreneurs to undertake projects for which there are insufficient real resources to carry them out. They cannot all be brought to completion, because the increased credit extended is not funded by an increase in voluntary savings. Therefore, some of these projects must be liquidated. THIS is what causes the recession. It is PRECISELY the issuing of fiduciary money that causes cyclical unemployment. It, therefore, cannot be its cure.

  6. Shawn,

    I hope you are as open minded as you ask others to be and have enough Christian humility to consider the possibility that just maybe a Rothbardian view of money may not have all the truths. For there are other Christians and Austrians that do find merit in fractional reserve free banking and do take monetary disequilibrium seriously. Along those lines, here are some thoughts:

    First this:
    "An excess demand for real cash balances cannot be offset merely by increasing the nominal money supply, because the additional money will reduce the purchasing power of money relative to what it would otherwise be, which reduces real cash balances"

    The very problem with excess money demand is that the unmet demand for money is causing a drop in nominal spending and, in turn, a drop in prices and or real output. Satiating that unmet demand for nominal money will stop this disruptive process. And yes, real balances will fall relative to where they were when there was an excess money demand problem and were elevated, but that is because money demand has been satiated and the economy is returning to normal(i.e. money hoarding falls and spending increases. BTW, I bet your former instructor, Leyland Yeager would find your statement troubling. (You have read his work on monetary disequilbrium, right?)

    And your point about spikes in money demand being anticipated is irrelevant. The concern is not with that, but with unanticipated money demand shocks that do happen in the real world. They exist and are disruptive to business and entrepreneurial activity. We ignore at our own peril.

    Second this:
    "On top of that is the ethical and legal problem of creating more than one legal claim to the same piece of property."

    This is nonsense. Every bank liability (i.e. deposit) is backed by a bank asset. There is a question of liquidity for these assets, but to claim there is some moral duplicity is outlandish. You deposit your funds and either the bank hold the money and or use it to buy another asset(loan, security, etc.). Either way, the deposit is backed up. And this is no secret to the public, there is no deception here.

    If this is immoral then so is every other financial intermediary that takes your money and holds only a fraction of it in cash on its balance sheets. Life insurance companies, for example, take your premium and reinvest them in other assets. If everyone died who held policies, so that there was a 'run' on life insurance companies they too would have a hard time liquidating their assets quickly to pay off their liabilities. Does this make life insurance immoral? No.

    What bothers me even more about your claim is that you attach it to God and moral truth. Think long and hard how self-righteous this sounds to other Christians who also understand money but sees things differently. There is room for disagreement here without being condemned to hell.

    And here is a well-known and scholarly Austrian, George Selgin, who sees merit in fractional reserve banking:



  7. Christian Economist,

    I am happy to discourse with you, however, I ask that you identify who you are. Surely fellow Christians can speak to one another using our names.