Steven Horwitz is a professor of economics at Ball State University and a senior affiliated scholar at the Mercatus Center at George Mason University. He joins Macro Musings to discuss monetary disequilibrium, the condition when the supply and demand for money are not aligned, which leads to either inflation or deflation. David and Steve also examine Austrian Business Cycle Theory – a theory of how “malinvestment” caused by bad policy leads to an unsustainable boom and inevitable bust. Steve also explains how monetary disequilibrium led to the Great Recession and offers some solutions for minimizing business cycles in the future.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]
David Beckworth: Steve, welcome to the show.
Steve Horwitz: Thanks, David. Thanks for having me. Very happy to be here.
Beckworth: We're glad to have you on. As I do all my guests, let me ask you, how did you get into economics?
Horwitz:Well, a couple things. When I was in high school, I was reading political theory, and interested in libertarian ideas and all kind of stuff. I went to the University of Michigan as an undergraduate, intending to be probably a computer science major at the time, and my second semester freshman year, I needed a fifth course. I thought to myself, "All right, Horwitz, if you're going to keep talking about all this libertarian nonsense, you probably should know some economics."
Horwitz: So I took an intro course and had the experience, I think, that almost every other economist has of, "Oh, yes." For me, it was like I knew this already at some level. It wasn't even like this was new and sort of the lights went on. As my roommate, who was also an econ major, and I used to say, "Economics is systematized common sense." Suddenly it was like, "Yeah, this is right." Major change, and I ended up majoring in economics and philosophy there, and then onto George Mason after that.
Beckworth: Very nice. Well, you've written a lot on monetary economics. I want to talk about today, particularly monetary disequilibrium theory. Now, this is something that I find very interesting and I find very compelling, so I'm glad to have you on to talk about it, but many of our listeners may never have heard of this idea before, so let's begin with a quick summary overview of what it is, and we'll flesh it out throughout the podcast. What's a quick overview of it?
The Basics and History of Monetary Disequlibrium Theory
Horwitz: I think the best way to think about it is, what happens when the supply and demand for money are not aligned? As we'll, I think, flesh out, another way to think about that is, what happens when people's actual holdings of money, their actual money balances, are not equal to what they desire to hold? They either have too much or too little, which suggests that whoever's supplying money is creating too much or too little. The fact that money is half of every exchange and is the commonly accepted medium of exchange means, when people have too much or too little money, it can't be isolated to just money; it's going to spill over into the goods market, broadly construed, and that's going to have implications there for the real economy.
Beckworth: All right. Let's begin our discussion of that by looking at its intellectual history. This idea goes all the way back to Wicksell, is that correct?
Horwitz: At least. As I was thinking about this, one arguably could include Carl Menger in there, and Menger's work on the origin of money, which really emphasizes money emerging out of exchange, but in what we would think today as macroeconomics, right, it's really in Wicksell, and Wicksell is the one who sort of began to systematize this set of relationships between money, the interest rates and the price level, and began to ask these questions: "What happens when you have too much or too little money? How does that relate to the interest rates?" It's certainly in Wicksell we see the natural versus market rate of interest distinction for the first time, and for Wicksell, part of that argument was, "All right, what's the implications for the price level?" He got some pieces of it wrong, I think, as we'll talk about, but certainly he had all of the elements of the story there.
Horwitz: From there, it goes off in a couple different directions from Wicksell. I think one direction you see is certainly in von Mises, in the theory of money and credit, and his later work where he really stressed the cash balance approach to money demand, and the idea that people have a definitive demand to hold money, and then what happens if we have excess? For Mises, the concern was excess supplies of money, but for certainly Mises' story of what became the Austrian business cycle theory in inflation is, one, the monetary disequilibrium story. At the same time, though, you have Wicksell influencing the early American monetarists, Davenport being the most obvious of those.
Horwitz: That becomes a kind of nother line here that runs through some of those thinkers in the teens, '20s and '30s. Another certainly important is Dennis Robertson, who was in this same kind of tradition. I think, too, Cannan is another important early figure here in the early 20th century. He influences a lot of these Americans. Another name to toss into this around that same time is William Hutt, the South African economist who was kind of a quasi-Austrian. Hutt has, again, same sort of emphasis on looking at the alignment between the supply and demand for money.
Horwitz: You can see, now we've got all these different branches. If we bring it a little more up to the present, one of the places this really manifests itself in the '60s and '70s is at UCLA, in Clower and Leijonhufvud's work, which is certainly in the Wicksellian tradition, I mean, Leijonhufvud very explicitly so, but also has some of that more modern monetarist element in it too. Larry White was of course a student at UCLA, and Larry White's work sort of re-fused some of that stuff with the Austrian tradition, and now we've got this modern Austrian version of this. Larry begat George Selgin, who begat me in many ways, and now there's a whole younger generation of folks who are pursuing this.
Horwitz: The one name I didn't mention, of course, is Leland Yeager, and Yeager is a kind of key figure here too. I think Yeager, again, comes out of that Cannan-Hutt early American monetarist tradition, and it's Yeager's work that I think is really the... the word I want here is, it's more than a fulcrum. The focal point among Wicksell, the early American monetarists, and also the Austrians. Yeager's work captures elements of all of those, and for me, that's the place I really started. At that sort of Yeager-Austrian combination for me is where I really started.
Beckworth: My first introduction to monetary disequilibrium was Yeager, and there's a book that has a collection of his essays. I recommend this to our listeners. It's called The Fluttering Veil: Essays on Monetary Disequilibrium. It's a really good read. I had to read it in grad school, but it's very accessible. Even an undergrad could handle it, so I would encourage listeners to get a hold of a copy and take a look at it.
Beckworth: Let's talk about Yeager's views, because I think that's probably one of the more common, at least one that reoccurs in terms of monetary disequilibrium. There's several assumptions in his view. Let's work through them. First one you've already mentioned, and that is money as a generally accepted medium of exchange. Why does that matter?
Horwitz: I think it matters for a couple of reasons. The way I like to put it, and I think I said this earlier too, is that money is half of every exchange. All exchanges essentially take place using money. We always talk in terms of, conventionally, about buying and selling goods, but at the same time, buying goods is selling money, and selling goods is buying money. Money in that sense touches everything, as half of every exchange. There's all kinds of metaphors here. My favorite is, it is like blood in that sense. We even talk about the circulation of money, and the circulation, right?
Horwitz: People kind of saw this, but why I like that analogy is that, because money is half of every exchange, when there's something wrong with money, it's going to affect all of those other things. When I teach this to undergraduates, I look at the class and say, "Has anyone in here had mono? Well, don't raise your hand; we don't really want to know, but if you've had mono, what happens when you have mono? You're just exhausted, because it's a blood disease. It's not just that your arm hurts or your leg hurts; your whole body is shutting down, because it's a blood disease and it's touching everything. It's affecting everything."
Horwitz: For me, that's why money matters when we think about macro models and we think about business cycle theory and all these sort of things. If money's not right, there's no... another way to put this, you can't isolate money to something called the money market. If shoe manufacturers make mistakes, we have a theory that tells us that the shoe market's supply and demand will adjust. We can, for the most part, see the adjustment in one market. There will be some spillover, but when money is wrong, there's no one place. It's everything. When money's wrong, everything's wrong.
Beckworth: That's the convincing argument. Money is the one asset on every market, every transaction, so if you want to mess up all markets, there's your way in.
Horwitz: And the flip of that, of course, is when you get money right, when monetary institutions are performing well, money does not become a interfering factor in the underlying exchange process. That's the notion of, money as a veil is very, it's contested historically. What exactly does that mean? But I think the truth of that is, at least when money is right, it's facilitating but not undermining those exchanges that are taking place. It can never do so perfectly, and I think that's important, but it's minimizing its negative impact on people's ability to engage in exchange.
Beckworth: Money is a search technology, right?
Beckworth: The idea of a medium of exchange. It makes our life easier. It makes us more productive. Output is higher than it would be in the absence of this search technology. This kind of realization really hit home when I was working on some monetary search models with one of my coauthors, Josh Hendrickson, in the following sense. Typically, we think of like a monetary policy shock or monetary disturbance in nominal terms, but really, if money is a search technology and you disrupt the technology, if I said any other technology and I said, "Let's have a negative productivity shock," you would say that's a real shock, right?
Horwitz: Right. Let's take an example. Think about Uber. If there's a technological problem with the app, that undermines the real exchanges that are taking place. You can't just say, "Well, it's an Uber." It's an everything problem. It's affecting all of those things. It's not just a... nominal and real aren't the right words here, but it has that kind of ripple effect in ways. People can't get to where they want to go more easily. Yeah.
Beckworth: Money is very, very important, and that's the first assumption. I think it's something that all undergrads are exposed to, but it's really maybe not as appreciated as it should be when you get to New Keynesian models, kind of the standard approach where everything's good in terms of interest rates, output gaps and inflation measures, and we lose sight of the fact that money is this intrinsic part of our daily lives that drives transactions. We need to take it seriously, and I think some of the monetary search models are doing a better job with that.
Beckworth: All right, that's assumption number one. Assumption number two, sticky prices.
Horwitz: Yeah. I think one of the key parts of the story, certainly in Yeager's version of it for sure, is the idea that when money is wrong, you can't just expect that prices will immediately and flawlessly adjust to take care of that problem. For example, think about inflation for a second, because this seems more obvious when we think about inflation. If we have inflation, we know in some sense prices are sticky. They don't adjust immediately and evenly. Our simple sort of helicopter model suggests that they do; we just increase M, V, and P goes up, but the problem with that aggregate price level is it's not telling us about the prices that constitute it underneath, and the sort of relative price effect arguments, which go way back to Cantillon and way back in the history of economics.
Horwitz: Once we recognize that those relative price effects are there, well, all relative price effects are is saying prices are sticky. Sometimes going up, right? We don't get even movements of prices when the money supply goes up, but going down too. This is, I think, a less intuitive point, perhaps, and we're kind of moving our way into the nuts and bolts of the story here, but suppose for a moment people find themselves with less money than they wish to hold. That is, their actual money balances are less than desired. They're unhappy. They're in disequilibrium, hence monetary disequilibrium. How do they solve this problem?
Horwitz: Well, really, there's basically three ways that individuals could potentially solve the problem. One, you could earn more income; two, you could sell off some assets. I'm going to stop and not do the third one yet. The problem with both of those, that requires that other people have money to pay you, but they don't have that, because presumably everybody is in this situation if we are in monetary disequilibrium. The third choice people have, of course, is to restrict their consumption. We can control that. We can each do that, and if we restrict our consumption and we continue to have regular income coming in, our money balances will slowly build themselves back up.
Horwitz: This is a key part of Yeager's story, this sort of regularity. The idea that we receive money on a regular basis. It doesn't require this conscious effort. If you have a job, you just get paid, and you get paid, and if your portfolio is short on money, you can increase your money balance by cutting your spending. Well, back to the sticky prices. What Yeager and people like Bob Greenfield and others have argued is that, when we all begin to restrict our consumption, sellers face a dilemma. If my demand is off, I'm feeling that pressure to lower my prices. If I cut my prices first, I'm risking losing revenue, but if everyone cut their prices at the same time, we have a kind of collective action problem, right? A who goes first problem.
Horwitz: Eventually, this will unstick itself as people begin to say, "I have to take that risk." But what the argument from the monetary disequilibrium theorists has been, that takes time. While that's taking time, you can imagine multiple millions of markets, all of which have prices stuck above what should be now the market clearing level, given where demand has shifted to. You have all of these prices that are too high. They have to come down to clear markets. It will take time. While they don't clear markets, we end up with, our excess demand for money produces an excess supply of goods. We've got stuff sitting around.
Beckworth: We've got recessions.
Horwitz: Yeah, yeah. We have idle resources, including humans, including human capital, and we end up... Wicksell described this very effectively in his early work, this downward spiral that takes place here. That's the story about how, and the sticky prices point is key, because if prices were perfectly and instantaneously flexible, as soon as people found themselves with too little money and began to restrict their demands, prices just adjust, and you don't have this.
Horwitz: It's a podcast so I can't do a visual, but if you imagine a vertical money supply curve and a downward-sloping money demand curve, the story that doesn't include sticky prices suggests we just jump from one equilibrium to another if that money demand curve shifts, but the Yeager monetary disequilibrium and Austrian stories are all about the process. We have to trace that process. We don't jump from equilibrium to equilibrium; we jump out to that disequilibrium, and then we slowly move our way back to the new equilibrium. That's what we'd call a recession.
Beckworth: That's in the name disequilibrium, is that you're stuck between two equilibrium points, right?
Beckworth: That there's an adjustment taking place, which is kind of contrary to the way we do economics. We always think we're in equilibrium, but what this says is we're not.
Horwitz: Right. I think there's a number of things that are interesting about that, and you can see from a history of economic thought perspective why a lot of the guys who did this work in the early 20th century would like it. This is before general equilibrium theory got locked in as the way, even partial, that we do this, and the ability to talk about process and so on. We could see it, it's even in Marshall, but certainly in the Austrians at the time and others.
Horwitz: Again, that's where Cannan and Hutt and these guys all fit in. They were all process people. To bring it to the present, who's interested in this? It's people often influenced by the Austrians and their emphasis on process and disequilibrium, and even Yeager. I think Yeager, despite his protestations, has one foot in the Austrian camp and one foot back in this old monetarist group. They're all interested in explaining that adjustment process, and recognizing that we need to understand what constitutes those equilibria, but where the action is is in the transition. Is in the process.
Beckworth: Just to recap, we've got some assumptions, number one being money as a medium of exchange; two, sticky prices; and the third one I think we've alluded to already, that people desire to hold a certain portion of their assets in the form of money. This is something I want to stress, and maybe you can articulate for us. That is, it's not a desire to hold an infinite amount of money; it's that, given the wealth we have, a certain portion is desired to be held in the form of money. Is that right?
Horwitz: Yeah, I think that's right, and I like thinking of it as a portfolio decision. I think sometimes in non-expert audiences the confusion here is between money and wealth. Look, we all might like an infinite amount of wealth in the broadest sense of the term, but money is not the same thing as wealth. There's other forms. Every time we purchase something, we're making a portfolio swap on some level. We're swapping money out for whatever it is that we buy. The idea here, and this is in Wicksell and Mises's stuff on the cash balance approach to money demand is the really good stuff here, the idea that people want to hold a certain portion of their wealth in the form of money.
Horwitz: There were problems with Keynes's version of this in the general theory, but he was on the right track with the transaction point, and even to some degree the precautionary point, that we don't know when we're going to spend. We need to make expenditures, so we hold money, because money has what are sometimes called availability services. It's like a waiting fire truck, or the umbrella you keep in your briefcase. You may not need it today, but it's there if you do. We don't think it's wasteful or silly that we have fire trucks parked in garages, because we're going to need them eventually. The other example I like is that we have clothes in a closet. We can imagine, and we might get there with software, where we have like the Uber of clothes or something, but-
Beckworth: Or 3D printing.
Horwitz: Right, right, but we keep clothes in our closet because you just never know when you're going to need it, and you want those options.
Beckworth: Okay. Now, if you look back at the great recession, 2008 to the present, one of the ways to see this, I've looked at it, anyhow, is to look at the flow of funds data, now call the financial accounts, which looks at the actual balance sheets of households and corporations. If you look at household balance sheets, look at their assets and look at the portion of their assets that are in highly liquid, safe asset form, it shoots up during the recession. Some of that is because real estate has collapsed, but some of it is, they are purposefully allocating their portfolio toward money, treasuries. Really safe, liquid assets.
Horwitz: Right. Liquidity, yep.
Beckworth: There's a conscious effort, so there's this spike, and it only slowly comes down over the years to the point where it's back to where it was pre-crisis. People are nervous. They're hanging onto these liquid assets until they see more certainty.
Horwitz: Right. We can talk maybe later more about the Great Recession in particular, but I think the one thing I'd say now is, that's the tricky part is that you do get this spike in the demand for liquidity, demand for money, essentially. Whatever your monetary institutions are, they'd better respond to that in the moment. If they don't respond to it in the moment, you're going to get that downward spiral that we were just talking about. I think for me, kind of at a personal level, it was very interesting. My book came out in 2000. That was in the Great Moderation. It was after Y2K, but before 9/11 and all that.
Horwitz: It got some attention. People liked it a lot, and along comes the crisis and the Great Recession. The publisher, Routledge, reissued it in paperback in January of 2009. Didn't even tell me. I found out like by accident, and it sold much better after that. In many ways, I wouldn't be on this show, because my career as a public intellectual, I think, came out of my ability to talk and just have the conversation we just had, to talk about the Great Recession in those ways. As I like to say, the Great Recession was bad for a lot of people, but the demand for Horwitz shot way up.
Beckworth: It's good for you.
Beckworth: Let's put this all together, then. Put these assumptions together, and what we want to have ideally is monetary equilibrium, so the desired amount of money balances what you actually are holding. Sometimes that doesn't happen. You just mentioned the Great Recession, Great Depression. A lot of examples we could go through, and they can happen from both sides. You can have either a sudden change in money demand or a sudden change in money supply, which leads to this monetary disequilibrium, which again is consequential, because money is the asset in every market. You can disturb all kinds of markets that way. Let's work through how that could happen. What would lead to a sudden change in money demand?
Causes of a Shift in Money Demand
Horwitz: Any of the factors we usually put in that money demand equation here. I don't think that the monetary disequilibrium theorists have a lot to say that's too different from standard theory, although I do think one of the mistakes in the old-time Keynesian story was to make the decision, that money-holding decision, with the speculative demand between money and bonds. We're going to go into a little detour here, but what happens there is that then the spillover of money is into the interest-bearing asset market. When you draw that Keynesian money demand and money supply curve, what's on the vertical axis? It's the interest rate.
Horwitz: That piece of Keynes obliterated the older story, which was to have the price level, or one over the price level, on that vertical, sort of value of money on that vertical axis. What that enabled you to see in thinking of it that way was, when you had the excess supply or excess demand for money, it spilled over into all of the goods markets. Just saying, kind of throwing all that into bonds for Keynes was... Keynes's aggregates concealed the most fundamental mechanisms of change. Hayek was talking about… money, but it's true of the general theory too, that you create this kind of composite good you call bonds, and it wipes out the role money plays as a medium of exchange, and spilling over in those ways.
Horwitz: I don't want listeners to take my... the difference isn't that large. I think that's an important difference right there. People want to hold money to make transactions, as precautionary, and sure, the interest rate plays as an opportunity cost. Plays some role if you're thinking of highly liquid stuff, but I don't think there's anything really distinctive there other than that money as a portion of your portfolio idea. People get nervous. Call it animal spirits if you want. People get nervous. They want to hold more money. They're worried, and again, here's where you get the complexities.
Horwitz: This is sort of the Fisher debt deflation story in some ways, but you can have a crisis that occurs for other reasons, and you get the secondary deflation, Hayek talked about this too, where people create recession. People get nervous about the real change, and then all of a sudden "Oh, we've got to go liquid," and now what do you do? All of those factors might cause a jump in the demand for money. Once that happens, we're back to the story we were talking about earlier. People, the only way they can satisfy that demand... assuming the central bank or the bank system doesn't do anything, the only way you and I can satisfy that is by restricting our consumption. Then we get that, spending falls, we get excess supplies of goods, idle goods and all that.
Beckworth: Right, so either there needs to be more money, an increase in the money supply-
Horwitz: Supply, or the factors-
Beckworth: The price level has to fall.
Horwitz: Right, right. Even there, when we say "The price level has to fall," it's a perfectly fine shorthand, but what we're really saying is, "The prices of every single good and service have to fall," and they're not going to fall equally, and they're not going to fall instantaneously. But you're right; the price level has to fall. If you think about the demand for money as a demand to hold real balances, you can just do the old sort of M over P story. It's, either the numerator or the denominator can adjust to clear that market. I'm speaking somewhat metaphorically here. If you find yourself with too little money, two ways to solve it: increase the numerator, decrease the denominator. In essence, changes the real money supply. Either way can do it.
Beckworth: Now, money demand also grows secularly or normally with income growth. If you look at any kind of measure of money, monetary base, M2, M3, it's growing over time. The Federal Reserve does not have a hard time with that type of growth, right?
Horwitz: Nope. Right.
Beckworth: If you look at the monetary base, in this case, it is gradually growing over time, and the Fed is able to accommodate that growth in currency demand. Why is it so much harder to accommodate a sudden spike in money demand? Is the Fed too slow? What is it?
Horwitz: There's a couple things happening here. I'm not sure the suddenness is the issue. This was a criticism raised about when I was first working on this stuff. I think that sort of secular growth, if it's true that the reason we see that secular growth in the demand for money is because we're seeing real growth in the economy, and that we need to accommodate that... well, if monetary institutions are working right, that real growth should involve a slow decline in the price level we have. As productivity increases, stuff gets cheaper. One way to think about it is, P is falling, so we can accommodate that real increase in the demand for money by a real increase in the value of the money supply through the productivity-generated falling price level. Again, this is pretty subtle stuff.
Horwitz: On the other hand, when what's happening is a spike in really, velocity is the word we want here, now you can't solve that. There's no inherent change in the price level taking place that can solve that through the denominator, sort of endogenously. Now the only way to solve it through the denominator... actually, endogenously isn't the right word. Solve it as part of the same process. The only way to solve that problem now is to increase the supply of money or to wait out that process, that contractionary process for prices to fall.
Horwitz: If you go back to the story we were telling earlier about the sticky prices and the who goes first problem, there's a sort of game theory, tragedy of commons problem there, almost, that when you need every price to fall, you have a who goes first problem. When economies grow, it's not that you need all prices to fall at the same time. Entrepreneurial innovation over here, over here, over here; slowly, that's the productivity. Individual prices fall. No one needs to wait for anyone else to do it, because the increase in productivity justifies you cutting output prices. Those are all decentralized individual decisions when we're talking about that secular growth, but when we're talking about either the increase in the demand for money across the board or a decrease in the supply of money across the board, then you've got this, again assuming there's no response from the monetary authority, tragedy of the commons, who goes first type problem.
Beckworth: Just to be clear though, the world we live in, the last 50, 60 years, has been one of rising price levels. We're not actually seeing a decline in P, right? In price level?
Horwitz: Right, right. This is the interesting theoretical question over that period is, clearly we've had productivity increases. If we had had monetary institutions that had maintained monetary equilibrium, we should have seen something like we saw in the late 19th century, which is, at least in the United States, that slow decline in the price level as a result of that increase in productivity. Here's the interesting part of this, which suggests that stable prices... and this is Wicksell's error back in the day. He thought monetary equilibrium would lead to stable prices, but he was missing that productivity piece. Monetary equilibrium will enable the price level to move inversely to productivity. That's what we want to happen, for a whole bunch of reasons. George Selgin's Less Than Zero-
Beckworth: Yeah, we had him on the show and he talked about that.
Horwitz: Yeah, about this. Yeah. It goes back to Hayek, and some more technical stuff in Hayek I think make this case very well. The goal of stable prices is a tricky one, and the Austrians, of course, talked about the 1920s this way. Austrians say there was inflation in the 1920s, but prices were stable. The broad-level Austrian response is, "Well, wait a second. It was also a time of amazing productivity increases. We should have seen falling prices in the '20s, and the stability of prices suggests that maybe there was an excess supply of money there as well."
Beckworth: Going back to the question of, why can't a central bank be aggressive enough when there's a sudden spike... for example, I could imagine, if we had institutions that do this, a massive helicopter drop. By that, it would be a fiscal... that's fiscal policy, I guess.
Horwitz: Right, but the question is, how do they know?
Beckworth: That's a good point.
Horwitz: How does the central bank know that there's been this increase in the demand for money? One of the problems, I think, with all macro policy, but especially perhaps money policy, is we don't know we're in trouble till we're in trouble. The indicators that we use to tell us, this is a sort of lag story, but the only way we might know that there's been this increase in the demand for money is we begin to see the spiral taking place.
Beckworth: Right. That's a fair point.
Horwitz: I think, when we talk about institutions and policy, the question becomes, what sorts of institutions will best be able to detect and respond quickly to those changes in the demand for money with the appropriate change in supply?
Beckworth: Right. For example, GDP in the fourth quarter of 2008 was massively revised down in subsequent years.
Beckworth: In real time, we didn't know... although there were asset prices we could look at that were suggesting things were going.
Horwitz: But suggesting, right? Two things. One, even without those revisions, you don't even know it's fallen until it's three months later. There's already three months taking place, and so many of those same debates took place in 1929, 1930, where it was a bigger problem because they really didn't have even the data that we have now. Certainly a lot of the errors the Fed made then was finding out... there were theoretical mistakes, but finding out too late what was happening in ways that they couldn't react. By then, it was too late to react to. I shouldn't say too late to react; too late to prevent significant problems.
Beckworth: All right, so we've been talking about excess money demand. Just to be clear to our listeners, we're talking about a situation here where people have a certain desired amount of money they want to hold, but they don't have that much because they're in a recession, and everyone is trying to… hold onto what they have, minimizing the outflow of money, trying to maximize the inflow through all the different channels you mentioned earlier. Let me ask this question about the money they hold. What form of money really matters? Is it M2 that matters? Is it the monetary base that matters? I bring this up because there was a big debate in the blogosphere a few years back, when Scott Sumner, Nick Rowe, maybe yourself and a few others. When we talk about the demand for money mattering, is it broad money supply?
What Form of Money Matters?
Horwitz: I think it's a fairly broad measure. This is tricky. What we care about is the use of... what do people use as media of exchange? What are people using to buy and sell things? That's what matters. Clearly, cash and checking accounts and the usual, sort of M2 or maybe MZM or one of these sort of measures, but I'm also fascinated by the Divisia idea. Could we come up with a weighted money supply that weights all the elements by how liquid, how medium of exchange-y they are, I think would be the way I'd put it. As a practical matter, there's no objective way to do this, but it seems to me theoretically that's what we're after.
Horwitz: A lot of people criticize Murray Rothbard's work on the Great Depression for constructing this extraordinarily broad measure of the money supply in the 1920s. I think he did go too far, but I don't want to lose the point, that you really do want to examine, what are people using? Just as one example, if you have a money market mutual fund account that's checkable, you can write checks off it, but you can't write a check for less than $500 dollars, should we count it? Well, not 100%, because unless I'm hungry, I can't really pay the grocery bill with it. At the same time, big enough payment, I'm doing something to my house or something, it is. It's just as good as a checking account. Right. Again, I don't have a precise answer because I'm not sure one is possible, but theoretically we want a broad measure that captures the medium of exchange-y-ness of...
Beckworth: So you want to capture any asset that facilitates transactions on a broad, generally accepted basis.
Horwitz: On a broad level, right, and recognizing that some of those will not do it perfectly, so that sort of weighting...
Beckworth: You're going to weight them based on their liquidity.
Beckworth: I think the Divisia Measure is a good one. William Barnett has done a lot of work on this, and the Center for Financial Stability in New York actually has a measure. They have the Divisia 4, Divisia 3, all the way down. I'll just put a plug in for a paper that Josh Hendrickson and I have done. We've gone through and have done some statistical work, some impulse response functions and vector autoregressions, and we show that if you have a sample that includes through the Great Recession, those broader ones do better than like-
Horwitz: Predictably, yeah.
Beckworth: Divisia 2, because you get reasonable responsiveness in the monetary theory. In any event, I don't want to get lost in that. The key point is, you want to use a broad measure of money when you're thinking about this issue, right?
Beckworth: It's any asset that people want to use as money and...
Horwitz: Right, and that's bond goods and services, and therefore affecting prices.
Beckworth: That's excess money demand, and excess money demand, I think, has been the focus of this monetary disequilibrium literature. Leland Yeager, when he wrote his work, he wrote an article on the cash balances interpretation of the Great Depression. The focus has been on that. I know when I've pushed this view, when I think about it, I've been thinking of it in the context of the Great Recession, but you can have a problem on the other side. You can have excess money supply. Tell us about that.
Horwitz: The excess money supply story is, what if people discover themselves to have greater money balances than they wish to hold? Now, again, that seems like, "Wait, how can you have too much money?" Again, distinguish money and wealth, and it's a portfolio question. If people find themselves, more precisely, with a greater percentage of their wealth in the form of money than they might wish to have, what do you do? Well, there's the easy thing: you spend it. You can make that portfolio adjustment very easily by trading money in for goods and services and going that way.
Horwitz: Of course, what happens when you do that? Well, prices go up. It's the flip version of what we were talking about earlier, that now that upward increase, you can imagine it as an increase in demand for every single good and service to some degree or another. That starts to drive prices up, and you have the same problem again. In the other story, we talked about the downward stickiness of prices generating excess supplies of goods and services. Now you've got inflation, and now you've really got the Austrian story coming in here, and in particular, the importance of those relative price effects that we mentioned earlier.
Horwitz: This is not a smooth helicopter drop across the board story. Specific people get their hands on that excess money first. They spend it on specific goods and services. You get what Mises called a price revolution, meaning that none of these prices are going to go up exactly the same. It's going to depend on who gets it first, what their various demands and margin utilities and all that micro-level stuff is, and now you've got prices moving all over the place.
Horwitz: That means relative price effects. That means some prices go up more, some go up less, and we know from basic micro, that means resource allocation is going to change. Those shifting relative prices are going to attract resources in some places; they're going to discourage it in others. We're going to get misallocations of resources thanks to that, and then, if you think about again the Austrian business cycle story of malinvestment, when you pull capital into this story-
Beckworth: What is malinvestment?
Defining ‘Malinvestment’ in Context
Horwitz: The Austrian story goes something like the following. Two things will happen here. One is that that excess supply of money will distort prices, as I've described. It will also drive the market rate of interest, that is, the rate banks are offering. They've got reserves to lend thanks to, presumably open-market operations have caused this excess supply. They've got reserves to lend. That will drive the market rate of interest below what Wicksell called the natural rate. The natural rate, the best way, I think, to think about the natural rate, it's the underlying price of time. It's a reflection of people's time preferences.
Horwitz: The problem is, we cannot trade time with each other directly. We trade it in the form of money and credit markets, loan markets. The loanable funds market, you can think of that as buying time and selling time in the form of money. When I borrow, I'm bringing things forward in time; when I lend, from my perspective, I'm pushing them later in time. We trade through time, probably is more precise.
Horwitz: What happens during this inflationary story is, you have the prices of some goods going up. Entrepreneurs say, "Hey, looks like a potential opportunity here." You have cheaper lending. Banks are lowering their interest rates, moving down that demand curve with the new supplies that they have. That attracts entrepreneurs to borrow for that, and they put it into capital goods, the Austrian story goes, and often they're putting it into capital goods with an eye towards making those things whose final goods prices have been higher.
Horwitz: The problem is is that, if all this is temporary, one of two things is true. If it's temporary, you might make major errors in what you've invested in. It turns out that that price increase you saw was temporary, not permanent, and there's a kind of Lucchesi story here, but the key part is you've invested in these capital goods whose costs are not all retrievable. If you invest in this good, some of those costs, some of those resources will be lost if you then have to adjust back six months or a year later.
Horwitz: The idea for Austrians that capital is manifest in capital goods that have heterogeneity and specificity means that we can malinvest. We can invest in not too much capital, but the wrong kinds of capital when we find ourselves in this situation. The Austrian business cycle theory more broadly, that story is, what you have is a lot of this malinvestment taking place as entrepreneurs are led to believe from the lower market rate that consumers are more patient, they're more willing to wait a longer period to get their output, but in fact they're not. That is a false signal being sent by the inflation.
Horwitz: Eventually, endogenously, this has to come to an end. Roger Garrison has called the Austrian business cycle theory "The theory of the endogenous bust," which is what the Austrian theory does is explain how, if you have inflation, that process will eventually generate a bust. What's happening is, the inflation, the false price signals and false interest rate signals from the inflation are leading people to make errors that will eventually be revealed.
Beckworth: An example of this I think an Austrian would point to would be the housing boom right before the housing bust, in the early to mid 2000s. Now, if I step back and I ask observers, other economists, what caused the housing boom, some of them will point to fed policy. John Taylor would say that, but some of them would also point to poor regulatory policies, maybe money flowing in from abroad, excess savings from abroad. There could be a number of distortions, a number of policies, a number of developments that could cause this to happen. My question is, can you get this malinvestment, can you get this excess money supply, endogenously? Can you get it independent of, say, the central bank, or is this all a central bank story?
Horwitz: Yeah. I think it's ultimately a central bank story, either errors of commission or omission. A couple ways of thinking about this. You can certainly get it if a central bank just engages in expansion [inaudible]. That's the easy story. Suppose, alternatively, the demand for money falls, and people simply, for a variety of reasons, might not wish to hold as much money. They basically up their spending. The question then is, what's the banking system's responsibility? You're going to get inflation of a sort if they don't respond by somehow reducing the quantity of money that's out there. Again, that's the whole monetary equilibrium, disequilibrium point, is you want the money supply to have that kind of responsiveness and flexibility.
Horwitz: I think what can't happen, though, is regulatory policy on its own can't cause this problem. Regulatory policy might cause a drop in the demand for money if people are holding more of their portfolio in housing than in cash, but the problem comes in when the banking system doesn't respond to that change in the demand for money. When I look at the Great Recession, what I see is the confluence of all those things that you talked about. What you had was expansionary policy in the first decade of the century, whatever we're calling it these days, the 2000s, but that got steered into the housing market because of poor regulatory policy that made housing artificially attractive as an investment.
Horwitz: You ended up in the housing market with a couple things. You had malinvestment in construction and real estate, too many real estate agents, and too many bankers and financiers probably too. You had distortion of human and physical capital there, that kind of malinvestment taking place. Remember, the Austrian story hinges on that interest rate mechanism. Historically, what Mises and Hayek and others said was that it would go into commercial loans and those, sure, but if you have these poor policy that's siphoning that excess credit off into the housing market, why shouldn't it go into housing? It's interest-sensitive, right? There's no fundamental difference there.
Horwitz: What you got was a boom that was focused on housing, and then we can add the other piece of the story. Once housing prices started to go up and seemed to be going up, we built this whole other set of financial instruments on top of that, all of the mortgage-backed securities and so on, which were broadly premised on the belief that housing prices would never go down, because if they never went down, we'd still be living in that sort of utopia. As long as they didn't all go down at once, I guess we should be more precise, conceivably, yeah, everyone could build up equity in their house on $0 down, right? It would be great, but again, those rising housing prices were created by the combination of fed expansion and poor regulatory policy.
Beckworth: Here's a tough question. Which distortion is more problematic? Is it excess money demand or excess money supply?
Horwitz: I think it depends on the magnitude. Running a 1% or 2% inflation every year for five years is not going to be as damaging as a 10% drop in the money supply in one year. I think you have to think about length of time and magnitudes. One of the differences is, and this is a point Leijonhufvud makes in his Costs of Inflation essay, which is just marvelous. He says, "Look, the costs of inflation are subtle and hidden, and we don't see them, and we don't recognize them as being caused by inflation." It looks like the market is just messed up, whereas deflation, it happens more quickly and suddenly, and it's easier in some ways to identify it, especially when you throw the Austrian point in there that there's this kind of, there's a bust coming; we don't know exactly when, but during the boom, everything looks great.
Horwitz: One of the interesting parts of that Austrian story that I like to emphasize, both in my professional work and to students, is you've got to remember that the mistakes are being made during the boom. The bust in the Austrian story is the healing corrective process. That's when we're trying to fix it. The unemployment that happens in the bust of an Austrian business cycle is a reflection of us, the economy, if we can put it this way, saying, "We had these resources in the wrong place. Now we've pulled them out of where they were, and we're trying to get them back to where they should be." That's the correction.
Horwitz: Krueger makes fun of this story all the time, but the sort of idea of a business cycle... Hayek compared it to a drug addict. I like to think about it like an alcohol binge. If you go out and drink, and you drink too much, and the next morning you wake up and you feel terrible, you don't say to yourself, "I must have done something stupid this morning to feel so bad." You did the stupid stuff last night. The feeling bad is a reflection of the mistakes you made the night before, and in fact, the feeling bad is your body's way of fixing itself.
Horwitz: I think that's an important point to remember here. We kind of started this whole thing on malinvestment. That's the malinvestment point, that the inflation generates all these errors, these systematic errors that then need to be corrected. That's, I think, the really hard question is, when you're in the bust, how do you now begin to correct those errors? This is where we found ourselves in 2007 and 2008.
Beckworth: Let me push back on that a little bit. Here's my take on what happened. We had, I think, policy probably too easy, which helped facilitate a boom. I can buy that there's malinvestment going on, but I question whether we needed a deep, steep recession to correct it. Maybe you agree with that.
Horwitz: I agree that we didn't need a deep, deep... let's talk about the adjectives here. What should have happened? We probably are in general agreement on this, I think. What should have happened? In the summer, fall of 2008, when we recognized and should have recognized what was happening, that's the point for me where the Fed had to open up the spigot and say, "Okay, we have a major problem here. The demand for liquidity is going through the roof. Let's provide all of that liquidity that people need now, and let's make sure they have it, and let's get it now." I think, had that happened, we wouldn't have had the deep, deep... would have had a recession, I think, of some sort, but not a deep, deep one.
Beckworth: I agree.
Horwitz: This is the 1929, 1930 story. We would have had a recession there, because I think we did have a boom in the '20s, but when you let the money supply drop by 30% over three-plus years, and, I should note, in the Depression story you have the money supply dropping, and you're trying to prop up prices in all the bad Hoover policies. It's a perfect storm of nastiness, and I think we had a smaller version of that in 2007, 2008. I think where we might disagree, and where I think it's more difficult to sort out what to do, is kind of after the immediate crisis. Then we talk about QE and all that, which I think was a mistake, but arguably, if we'd done the right things in the first place, we probably wouldn't have needed to even think about those things later on. Here's another great sort of, make the one mistake and you compound it with further mistakes because your earlier mistake makes them seem plausible.
Beckworth: If you look at housing, it peaks in early 2006, and it's in a recession since 2006, so I think we see this corrective, at least in the housing sector we see a recession going on for several years before we get to 2008, where it really turns bad. You go from a garden-variety recession to the Great Recession, and in my view that could have been avoided. I guess this is where I'm a little maybe more sanguine about the healing properties of our economy, if things are going right, in the sense that, from 2006 to mid 2008, there were some problems in the financial system, there were some problems in housing, but we were handling it relatively well. If you look at employment outside of any kind of construction or real estate industry, it actually was growing. It was absorbing the loss in an effective way.
Horwitz: Right, and the question, I think, is... again, all counterfactuals here, right?
Beckworth: Right, absolutely.
Horwitz: The question is, how well could that corrective process, I won't call it a recession, that corrective process been relatively isolated to the housing and housing-related industries? My only concern about saying it could be is, you had this whole financial infrastructure built in top of it. There's all kinds of reasons that happened, but mostly bad policy. Once you have that, then the ability of... money is a …exchange, right? The ability of a problem in a sort of real sector to become a monetary problem, and then spread to other real sectors, is channeled potentially through those financial instruments.
Horwitz: That's, to me, one of the ways in which policy encouraged the mortgage-backed security industry and the CDO, all of that stuff that was happening, that's how we get the deep, deep. That's why it's the Great Recession and not just another one. I think then certainly the Fed not managing it well in the fall of 2008, and I think also then there were further policy errors in 2009 and '10, real regulatory type policy errors that made this more difficult. One of the great teaching experiences of my career is I was teaching American Economic History in the fall of 2008. It's really 20th century, kind of Progressive Era forward type course, and we hadn't gotten to the Great Depression yet, but we were almost there in September.
Beckworth: Nice timing.
Horwitz: Nice timing. I would walk into class every day, and we were reading Bob Higgs's Crisis and Leviathan, so I walked into class every day, and the first thing we would do is turn the TV on. "Let's see what's happening, and then let's talk about that, because you're watching economic history unfold before your eyes."
Beckworth: Yeah. Well, it's Monday morning quarterbacking here on the Macro Musings Podcast.
Horwitz: Yes, it is.
Beckworth: I just think, had the Fed not been as concerned about inflation in 2008... Part of the problem was it was concerned about what was then a commodity price shock, which is a supply side shock. Had it not been as concerned about inflation, been a little more aggressive, I do wonder if things could have turned out at least a little bit better.
Horwitz: Yes, I think so.
Beckworth: I recognize nonetheless that there was a buildup of debt, which makes any economy more susceptible, just like if I finance 100% of my mortgage, I'm more susceptible to a slight change in the asset price.
Horwitz: That's one other point to throw in here, and I think you've written about this, if I recall correctly. There was too much concern about deflation before that, right?
Beckworth: Yeah. Yes.
Horwitz: When you have a monetary disequilibrium perspective, you recognize that there's good and bad deflations. If it's a productivity-generated fall in the price level, great. Let it go. Stop worrying about that. That's what you want. Late 19th century, right? But when it's either an increase in the demand for money or decrease in supply, that's the one we worry about. I think, if we want to really unwind the tape on the Monday morning quarterbacking, we can go back and say-
Beckworth: Go back to 2000.
Horwitz: Yeah, go back to the first quarter of the game and see what happened.
Beckworth: That's a good point. I think probably the challenge that faces mainstream economists would be that they have a hard time appreciating the distinction between this good and bad deflation.
Beckworth: But Austrians, people on the right, have a hard time recognizing that there's good and bad inflation.
Horwitz: Right, or the way I would put that is that not every increase in the money supply is an inflationary one. I don't know if George has used this term, but others have. There's warranted increases in the money supply. I think there are what some call these sort of internet Austrians out there, for whom every increase in the money supply is... I mean, Rothbard basically says this. Every increase in the money supply is ipso facto bad, at least for Rothbard, if it's not an increase in the quantity of gold, but in money is bad, right? I think, no, that's a mistake.
Horwitz: The other interesting thing, I'll pick on my Austrian friends for a minute. If you read, in Man, Economy, and State, Rothbard also seems to suggest that prices are perfectly flexible downward. That he's not worried about the excess demand for money story, because prices will just adjust. I read that and I go, "Well, wait a second, Murray. Why won't they just adjust going up? Why is there an Austrian business cycle story?"
Beckworth: That's interesting. Lack of symmetry, huh?
Horwitz: Yeah, there's a lack of symmetry there. I think that Selgin and White have written on this point, this lack of symmetry point. I certainly bring it up in my Microfoundations and Macroeconomics book.
Beckworth: He thinks there's price flexibility going down, and I think maybe historically that might have been true, maybe in the 1800s, but today there's so many institutional changes-
Horwitz: Yeah, and writing it in 1962, '63...
Beckworth: He should have known better.
Horwitz: Yeah, I don't think you can...
Beckworth: Clearly he's blinded by his bias.
Horwitz: Right, and the focus on inflation.
Beckworth: Yeah. Okay. Let's talk about solutions. We live in a world where we have central banks. I'm very pragmatic about that. I know some Austrians are less pragmatic. They want to hold up the banner of truth, but given that we have fiat money, given that we have a central bank, how do we best address this tendency... not a tendency, this monetary disequilibrium potential?
Solutions in the Face of Monetary Disequlibrium
Horwitz: Well, I'll say one word for the truth, which is, if it were up to me, I think a free banking system can do this. One of the arguments I make in my book is why I think a free banking system would do this, but to go to your question, given that we're in the world of the fifth or tenth or whatever best, what do we do? I think about the best we can do is an NGDP target of some kind. There's questions. Now here come the questions. NGDP target broadly achieves monetary equilibrium by... if you want to think in terms of the equation of exchange, if what we mean by monetary equilibrium is the left side, the M times V side is either stable or grows at a predicable rate, what that means is the same is true of the right side. If you want that M times V to be stable or growing at a stable rate, you've got to have PY, nominal GDP, doing the same. That's the simple case for me. That's what I think, by the way, that free banking would do.
Horwitz: Can and will the Fed do this is a different question, and does the Fed have the incentives to do it? Does it have the knowledge? Does it face knowledge problems? The sort of robust political economy questions that I think are legitimate ones to ask, and I think they do mean that, even if you think NGDP targeting of some sort is the least bad of all the alternatives, it's going to be far from perfect. I have my Austrian friends who say, "Well, the Fed should do nothing. That's the real… because anything you tell the Fed to do is going to be a problem. Fed should do nothing." But what does that mean? You can't even say "Do nothing," because that means doing something, or not doing something.
Horwitz: I don't know what they mean by that. Do they mean a fixed money supply? If so, that's a problem from a monetary equilibrium perspective. Or do they just mean we, as economists, should shut the hell up, because we don't have the knowledge to know exactly what we should... because if we were in charge of the Fed, we wouldn't know what to do either. I get that point and I respect that argument, but I still think it's okay to say "The Fed should do NGDP targeting" or whatever, instead of all the other things it might do, if one really thinks the other things it might attempt to do will make matters worse than attempting to target NGDP. That's my view. I'm sure that, I'm not going to name names, but when the people in question listen to this, I'm going to hear about it on Facebook or somewhere. That's all right.
Beckworth: We're glad to-
Horwitz: I'm tough. I can take it.
Beckworth: We're happy to add to your misery. No, so nominal GDP targeting is a way to handle monetary disequilibrium.
Beckworth: Great ending to our show today. We are out of time. Our guest has been Steve Horwitz. Steve, thank you so much for being on the show.
Horwitz: Thank you for having me. This has been a lot of fun.