Archive for the 'Bob Murphy' Category

Those Dreaded Cantillon Effects

Once again, I find myself slightly behind the curve, with Scott Sumner (and again, and again, and again, and again), Nick Rowe and Bill Woolsey out there trying to face down an onslaught of Austrians rallying under the dreaded banner (I won’t say what color) of Cantillon Effects. At this point, the best I can do is some mopping up by making a few general observations about the traditional role of Cantillon Effects in Austrian business cycle theory and how that role squares with the recent clamor about Cantillon Effects.

Scott got things started, as he usually does, with a post challenging an Austrian claim that the Federal Reserve favors the rich because its injections of newly printed money enter the economy at “specific points,” thereby conferring unearned advantages on those lucky or well-connected few into whose hands those crisp new dollar bills hot off the printing press first arrive. The fortunate ones who get to spend the newly created money before the fresh new greenbacks have started on their inflationary journey through the economy are able to buy stuff at pre-inflation prices, while the poor suckers further down the chain of transactions triggered by the cash infusion must pay higher prices before receiving any of the increased spending. Scott’s challenge provoked a fierce Austrian counterattack from commenters on his blog and from not-so-fierce bloggers like Bob Murphy. As is often the case, the discussion (or the shouting) produced no clear outcome, each side confidently claiming vindication. Scott and Nick argued that any benefits conferred on first recipients of cash would be attributable to the fiscal impact of the Fed’s actions (e.g., purchasing treasury bonds with new money rather than helicopter distribution), with Murphy et al. arguing that distinctions between the fiscal and monetary effects of Fed operations are a dodge. No one will be surprised when I say that Scott and Nick got the better of the argument.

But there are a couple of further points that I would like to bring up about Cantillon effects. It seems to me that the reason Cantillon effects were thought to be of import by the early Austrian theorists like Hayek was that they had a systematic theory of the distribution or the incidence of those effects. Merely to point out that such effects exist and redound to the benefits of some lucky individuals would have been considered a rather trivial and pointless exercise by Hayek. Hayek went to great lengths in the 1930s to spell out a theory of how the creation of new money resulting in an increase in total expenditure would be associated with a systematic and (to the theorist) predictable change in relative prices between consumption goods and capital goods, a cheapening of consumption goods relative to capital goods causing a shift in the composition of output in favor of capital goods. Hayek then argued that such a shift in the composition of output would be induced by the increase in capital-goods prices relative to consumption-goods prices, the latter shift, having been induced by a monetary expansion that could not (for reasons I have discussed in previous posts, e.g., here) be continued indefinitely, eventually having to be reversed. This reversal was identified by Hayek with the upper-turning point of the business cycle, because it would trigger a collapse of the capital-goods industries and a disruption of all the production processes dependent on a continued supply of those capital goods.

Hayek’s was an interesting theory, because it identified a particular consequence of monetary expansion for an important sector of the economy, providing an explanation of the economic mechanism and a prediction about the direction of change along with an explanation of why the initial change would eventually turn out to be unsustainable. The theory could be right or wrong, but it involved a pretty clear-cut set of empirical implications. But the point to bear in mind is that this went well beyond merely saying that in principle there would be some gainers and some losers as the process of monetary expansion unfolds.

What accounts for the difference between the empirically rich theory of systematic Cantillon Effects articulated by Hayek over 80 years ago and the empirically trivial version on which so much energy was expended over the past few days on the blogosphere? I think that the key difference is that in Hayek’s cycle theory, it is the banks that are assumed somehow or other to set an interest rate at which they are willing to lend, and this interest rate may or may not be consistent with the constant volume of expenditure that Hayek thought (albeit with many qualifications) was ideal criterion of the neutral monetary policy which he favored. A central bank might or might not be involved in the process of setting the bank rate, but the instrument of monetary policy was (depending on circumstances) the lending rate of the banks, or, alternatively, the rate at which the central bank was willing lending to banks by rediscounting the assets acquired by banks in lending to their borrowers.

The way Hayek’s theory works is through an unobservable natural interest rate that would, if it were chosen by the banks, generate a constant rate of total spending. There is, however, no market mechanism guaranteeing that the lending rate selected by the banks (with or without the involvement of a central bank) coincides with the ideal but unobservable natural rate.  Deviations of the banks’ lending rate from the natural rate cause Cantillon Effects involving relative-price distortions, thereby misdirecting resources from capital-goods industries to consumption-goods industries, or vice versa. But the specific Cantillon effect associated with Hayek’s theory presumes that the banking system has the power to determine the interest rates at which borrowing and lending take place for the entire economy.  This presumption is nowhere ot my knowledge justified, and it does not seem to me that the presumption is even remotely justifiable unless one accepts the very narrow theory of interest known as the loanable-funds theory.  According to the loanable-funds theory, the rate of interest is that rate which equates the demand for funds to be borrowed with the supply of funds available to be lent.  However, if one views the rate of interest (in the sense of the entire term structure of interest rates) as being determined in the process by which the entire existing stock of capital assets is valued (i.e., the price for each asset at which it would be willingly held by just one economic agent) those valuations being mutually consistent only when the expected net cash flows attached to each asset are discounted at the equilibrium term structure and equilibrium risk premia. Given that comprehensive view of asset valuations and interest-rate determination, the notion that banks (with or without a central bank) have any substantial discretion in choosing interest rates is hard to take seriously. And to the extent that banks have any discretion over lending rates, it is concentrated at the very short end of the term structure. I really can’t tell what she meant, but it is at least possible that Joan Robinson was alluding to this idea when, in her own uniquely charming way, she criticized Hayek’s argument in Prices and Production.

I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time. The general tendency seemed to be to show that the slump was caused by [excessive] consumption. R. F. Kahn, who was at that time involved in explaining that the multiplier guaranteed that saving equals investment, asked in a puzzled tone, “Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemploy- ment?”‘ “Yes,” said Hayek, “but,” pointing to his triangles on the board, “it would take a very long mathematical argument to explain why.”

At any rate, if interest rates are determined comprehensively in all the related markets for existing stocks of physical assets, not in flow markets for current borrowing and lending, Hayek’s notion that the banking system can cause significant Cantillon effects via its control over interest rates is hard to credit. There is perhaps some room to alter very short-term rates, but longer-term rates seem impervious to manipulation by the banking system except insofar as inflation expectations respond to the actions of the banking system. But how does one derive a Cantillon Effect from a change in expected inflation?  Cantillon Effects may or may not exist, but unless they are systematic, predictable, and unsustainable, they have little relevance to the study of business cycles.

On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory

Robert Murphy, a clever fellow with an excessive, but, to his credit, not entirely uncritical (see here and here), devotion to Austrian Business Cycle Theory (ABCT), criticized my previous post about ABCT. Murphy’s criticism focuses on my alleged misreading or misrepresentation of Mises’s original version of ABCT in his The Theory of Money and Credit. (Note, however, that we are both dealing with the 1934 translation of the revised 1924 edition, not the original 1912 German text.)

Murphy quotes the following passage from my post focusing especially on the part in bold print.

[T]he notion of unsustainability [in Austrian business cycle theory] is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

The original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard.

Murphy then chastises me for not having read or having forgotten the following statement by von Mises.

Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose.

Now it’s true that I did not recall this particular passage when writing my post, but the passage is not inconsistent with the point I was making. If you look at the passage from section 4 of chapter 5 of Part III of The Theory of Money and Credit (p. 357 of the 1934 edition), you will see that the context in which the statement is written is a hypothetical example in which banks can engage in an unlimited credit expansion without the constraints of an internal or external drain on their balance sheets. So while it is true that Mises anticipated in The Theory of Money and Credit the question whether a banking system not constrained by any internal or external drains could engage in an unlimited credit expansion, Mises was engaged in a hypothetical exercise, not the analysis of any business cycle ever encountered.

Murphy provides two longer quotations from a bit later in the same chapter in which Mises tried to explain why an unlimited credit expansion would be unsustainable:

The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall. (p. 362)

And

If our doctrine of crises is to be applied to more recent history, then it must be observed that the banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their own part and on the part of all those who had not forgotten the earlier crises, or whether because they had to defer to legislative regulations concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. If the stress is laid upon the word postpone, then this line of argument can be assented to without more ado. Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse. (p. 365)

The latter quotation actually confirms my assertion that Mises’s theory of business cycles as a historical phenomenon was a theory of the effects a credit expansion brought to a close by an external constraint imposed on the banks by the gold standard or perhaps by some artificial legal constraint on the reserve holdings of the banks. It is true that Mises hypothesized that a credit expansion by a completely unconstrained banking system was inevitably destined to be unsustainable, but this is a purely theoretical argument disconnected from historical experience.

But that is just what I said in my post:

[D]espite their antipathy to proposals for easing the constraints of the gold standard on individual central banks, Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation. This was a fine argument, anticipating the argument of Milton Friedman and Edward Phelps in the late 1960s by about 30 or 40 years. But that was an argument that the effects of central-bank expansion would tend to diminish over time as its effects were anticipated. It was not an argument that the expansion was unsustainable.

So let’s go back to what Mises said in the middle quotation above, where he tries to do the heavy lifting.

[D]espite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable.

I don’t understand why there has been no increase in intermediate products. The initial monetary expansion causes output to increase temporarily, allowing the amount of intermediate products to increase, and the average period of production to lengthen.

But there cannot be the slightest doubt as to where this will lead.

Note the characteristic Misesian rhetorical strategy: proof by assertion. There cannot be the slightest doubt that I am right and you are wrong. QED. Praxeology in action!

A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods.

Are the means of subsistence a common property resource? When property rights don’t exist over resources, those resources run out. The means of subsistence are owned and they are sold, not given away or taken at will. As their supply dwindles, their prices rise and consumption is restricted.

This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital.

But the whole point is that monetary expansion is raising the prices of consumption goods thereby imposing forced saving on households to accommodate the additional investment.

The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon.

What does this mean? Are workers dying of starvation? Is Mises working with a Ricardian subsistence theory of wages? But wait; let’s read on.

Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.

OK, so what is the point? What is unsustainable about this?

Now I am really confused.  But wait!  Look at the preceding paragraph, and read the following:

Now it is true that an increase of fiduciary media brings about a redistribution of wealth in the course of its effects on the objective exchange value of money which may well lead to increased saving and a reduction of the standard of living. A depreciation of money, when metallic money is employed, may also lead directly to an increase in the stock of goods in that it entails a diversion of some metal from monetary to industrial uses. So far as these factors enter into consideration, an increase of fiduciary media does cause a diminution of even the natural rate of interest, as we could show if it were necessary. But the case that we have to investigate is a different one. We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit-issuing banks and necessarily followed by the rest of the loan market. The power of the banks to do such a thing has already been demonstrated. (pp. 361-62)

So von Mises actually conceded that monetary expansion by the banks could reduce the real rate of interest via the imposition of forced savings caused by a steady rate of inflation. Unsustainability results only when the central bank reduces the rate of interest below the natural rate and succeeds in keeping it permanently below the natural rate. The result is hyperinflation, which almost everyone agrees is unsustainable. We don’t need ABCT to teach us that!  But the question that I and most non-Austrian economists are interested in is whether there is anything unsustainable about a steady rate of monetary expansion associated with a steady rate of growth in NGDP.  Answer: not obviously. And, evidently, even the great Ludwig von Mises, himself, admitted that a steady monetary expansion is indeed sustainable.  You can look it up.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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