WEBVTT NOTE Monetary Disequilibrium Theory: An Unstable Foundation for the Theory of Free Banking 1 00:00:00.000 --> 00:00:11.000 This is a vast field, monetary disequilibrium theory and free banking, and in my 17 and a half minutes, I just want to cover or concentrate on one area. 2 00:00:11.000 --> 00:00:26.000 So what I'd like to argue is that the claims of the monetary disequilibrium theorists with respect to free banking have nothing to do with monetary disequilibrium. 3 00:00:26.000 --> 00:00:33.280 In fact, it might even be more strongly stated, they don't really have anything to do with money at all. 4 00:00:33.280 --> 00:00:40.320 So let me start with just describing the argument that is made. 5 00:00:40.320 --> 00:00:48.640 I've taken this from George Selgin's paper on monetary equilibrium and productivity norm. 6 00:00:48.640 --> 00:00:51.080 So the argument goes like this. 7 00:00:51.080 --> 00:00:57.380 The problem starts because there is no separate money market in which money demand and money 8 00:00:57.380 --> 00:01:00.760 supply can clear. 9 00:01:00.760 --> 00:01:05.280 And because of this, if we have excess demand for money, if money demand exceeds the money 10 00:01:05.280 --> 00:01:12.000 stock, then there would be deficient, effective demand for goods or under consumption. 11 00:01:12.000 --> 00:01:17.280 This generates losses and then sets in motion a depressing effect on the economy. 12 00:01:17.280 --> 00:01:23.800 If the money stock exceeds money demand, then there's excessive effective demand for goods, 13 00:01:23.800 --> 00:01:28.800 and we get profits and then a boom period. 14 00:01:28.800 --> 00:01:35.200 So monetary disequilibrium sets in motion macroeconomic fluctuations in this argument, 15 00:01:35.200 --> 00:01:44.400 which can be offset by a regime of free banking in which changes in fiduciary media exactly 16 00:01:44.400 --> 00:01:48.600 really accommodate changes in money demand, so money demand increases and then fiduciary 17 00:01:48.600 --> 00:01:53.960 media would increase and counteract any depressing effect. 18 00:01:53.960 --> 00:02:03.800 The other part of the argument, which I would again claim is the central core of the argument, 19 00:02:03.800 --> 00:02:08.760 is that the changes in prices necessary to accommodate changes in the money relation 20 00:02:08.760 --> 00:02:12.600 without free banking do not occur in a timely manner. 21 00:02:12.600 --> 00:02:14.600 Price Stickiness 22 00:02:14.600 --> 00:02:25.600 No entrepreneur has incentive to lower his price of output and demands for inputs first because of the diffuse nature of changes in the money relation. 23 00:02:25.600 --> 00:02:38.600 No entrepreneur wants to absorb more of the decrease in the price of his own good than would be necessary to account for the general increase in the purchasing power of money. 24 00:02:38.600 --> 00:03:01.120 George Selgin also says that, he puts it a different way, he says the entrepreneur can't tell a general change in the demand for his product that comes from a change in the demand for money from a change in the demand from his product that comes just from a change in demand for his product alone and so it confuses him and he can't see the difference. 25 00:03:01.120 --> 00:03:12.620 Okay, so let me start with this concept of monetary disequilibrium. I've taken these quotations from Steve Horowitz's book, Microfoundations and Macroeconomics. 26 00:03:12.620 --> 00:03:21.120 This is the claim he makes that I made at the beginning. There's no unnecessary relationship between monetary equilibrium and general equilibrium. 27 00:03:21.120 --> 00:03:30.120 Here I think is the correct way of looking at this. If we have a system in general equilibrium, we can depict it in one of two alternative ways. 28 00:03:30.120 --> 00:03:33.880 These are simply alternative methods of describing the same thing. 29 00:03:33.880 --> 00:03:37.480 We have a single coin of general equilibrium that we can describe either on the obverse 30 00:03:37.480 --> 00:03:39.360 side or the reverse side. 31 00:03:39.360 --> 00:03:43.860 The obverse side would be the set of goods, the left-hand graph. 32 00:03:43.860 --> 00:03:46.520 The obverse side would be the money market. 33 00:03:46.520 --> 00:03:49.120 So these are just, again, alternative ways of saying the same thing. 34 00:03:49.120 --> 00:03:54.680 There is no necessity of having a separate money market because these two things are 35 00:03:54.680 --> 00:03:59.520 either simultaneously in equilibrium or they're simultaneously in disequilibrium. 36 00:03:59.520 --> 00:04:06.520 There's an exact relationship, in fact, between the goods market and the money market, contra Horowitz. 37 00:04:06.520 --> 00:04:13.520 Now, they may respond to this sort of thing by saying, well, that's not exactly the crux to the argument. 38 00:04:13.520 --> 00:04:18.520 Maybe we could go along with this and it wouldn't disturb our claim. 39 00:04:18.520 --> 00:04:21.520 So they go on to this other argument. 40 00:04:21.520 --> 00:04:27.520 Horowitz puts it this way, that the key claim of the study is that monetary disequilibria 41 00:04:27.520 --> 00:04:32.520 and the monetary equilibrium manifest themselves through disrupting the informational properties of price. 42 00:04:32.520 --> 00:04:43.520 If the monetary system is not sound, that is, if it's not free banking, then monetary calculation is less reliable due to the noisy influence of monetary disequilibria on prices. 43 00:04:43.520 --> 00:04:52.520 So there's something like relative prices among the goods and then there's monetary prices and the monetary prices introduce noise into the price signals. 44 00:04:52.520 --> 00:05:01.520 But again, I think the response to this, the correct way of viewing this is simply to remember that these prices are all determined by preferences that people have. 45 00:05:01.520 --> 00:05:13.520 And so all we have at the beginning that sets in motion the causal effect that we see in prices is we have people who have preference ranks where they're ranking goods against money. 46 00:05:13.520 --> 00:05:24.520 And notice, if they change then, and money is ranked higher than goods, we cannot tell whether this came from the good side or the money side. 47 00:05:24.520 --> 00:05:31.520 There is no point in discussing this. There is no point in trying to disentangle these two. They can't be disentangled. 48 00:05:31.520 --> 00:05:41.520 It's always money is valued relative to goods. And so, as we move from the left to the right, we're describing simultaneously again, 49 00:05:41.520 --> 00:05:50.520 or we could describe this as either an increase in the value of money relative to goods or a decrease in the value of goods relative to money. 50 00:05:50.520 --> 00:05:55.520 So there's no distinction here to be made. 51 00:05:55.520 --> 00:06:07.520 The next thing that I'd like to, the next level of how this argument proceeds, again we can see from Horowitz's book. 52 00:06:07.520 --> 00:06:13.820 So he might say, well, okay, that's not really what we mean, that, you know, that's not that important, let's go on to something else. 53 00:06:13.820 --> 00:06:23.420 If money is insufficiently supplied in comparison to demand to hold it, then we're unable to translate our productivity, what he calls notional demands, into effective demands. 54 00:06:23.420 --> 00:06:30.120 So the idea here is that when our demand for money increases, since it's not directly demand for goods, 55 00:06:30.120 --> 00:06:37.520 Then it can get sort of bound up in hoarding and it doesn't express itself as demand for goods, per se. 56 00:06:37.520 --> 00:06:49.600 Now, it seems to me, though, if that were true, I would dispute that it is true, but if that were true, then the solution would not be the regime of free banking that they argue for. 57 00:06:49.600 --> 00:06:54.840 It would be a system of commodity money, because then money, in fact, would be a good. 58 00:06:54.840 --> 00:06:58.280 And when money demand went up, it would increase the price of a good. 59 00:06:58.280 --> 00:07:04.440 and it would set in motion increased production of the good, the commodity, money, and then 60 00:07:04.440 --> 00:07:09.960 again we would have no distinction, right, there would be no difference between an increase 61 00:07:09.960 --> 00:07:13.640 in demand for money and an increase in demand for other goods. 62 00:07:13.640 --> 00:07:19.120 Okay, so they're not done yet, they go on with another claim that they make about how 63 00:07:19.120 --> 00:07:24.880 the real problem is that when money demand increases its effect is diffused through the 64 00:07:24.880 --> 00:07:32.280 the whole economy, and that causes the problem relative to when goods demand increases, that's 65 00:07:32.280 --> 00:07:37.800 just limited to the goods market itself, to a limited number of markets. 66 00:07:37.800 --> 00:07:42.320 So the real problem is money is general and its effect is felt all at once, all through 67 00:07:42.320 --> 00:07:48.800 the markets, and goods changes are just felt in one market or in limited markets. 68 00:07:48.800 --> 00:07:52.160 But again, this doesn't seem quite right to me. 69 00:07:52.160 --> 00:08:01.160 If that really is the argument, then this ill effect of increasing demand for different things, it sets in motion a deflationary depression, 70 00:08:01.160 --> 00:08:06.160 would depend solely, not on money, but solely on the saleability of goods. 71 00:08:06.160 --> 00:08:12.160 If the saleability of goods was widespread, well, then it would have this widespread effect. 72 00:08:12.160 --> 00:08:18.160 Money is just the most saleable good in the market, right? But there are other, generally saleable goods, 73 00:08:18.160 --> 00:08:30.040 In order to put the problem on the other side of the coin, it's certainly possible that 74 00:08:30.040 --> 00:08:36.720 an increased demand for money could be restricted in its obverse effect to just a few goods. 75 00:08:36.720 --> 00:08:40.180 I can increase my demand for money and reduce my demand for just one good. 76 00:08:40.180 --> 00:08:42.080 It doesn't have to be diffuse, right? 77 00:08:42.080 --> 00:08:45.360 Again, it doesn't seem to me to have anything to do with money. 78 00:08:45.360 --> 00:09:09.360 Okay, so the next line of argument that they suggest is that what they really are saying is that if we could conceive of money as being kind of a neutral element where the demand for some goods goes up and the demands for other goods go down, but they sort of move around money, then we would not have this effect. 79 00:09:09.360 --> 00:09:39.360 So here, I would depict it this way. Let's suppose we have, you know, demand or preferences this way, and then they just switch order around money, so money is staying in the middle, and they would say, this is fine, this sort of thing is fine, but again, I would say, well, I don't think this is fine with respect to the argument they make, because they claim again that when prices, when we have falling demand in certain markets, 80 00:09:39.360 --> 00:09:40.360 and so on. 81 00:09:40.360 --> 00:09:41.360 It's prices start to go down. 82 00:09:41.360 --> 00:09:44.800 And entrepreneurs don't know how to respond to this. 83 00:09:44.800 --> 00:09:48.240 They're not sure whether this is noise or whether this is change in relative prices 84 00:09:48.240 --> 00:09:49.240 and so on. 85 00:09:49.240 --> 00:09:50.240 They can't distinguish this. 86 00:09:50.240 --> 00:09:52.200 And so we would get the same problem here, right? 87 00:09:52.200 --> 00:09:57.760 We'd have falling prices in the Apple market and related markets here and we'd have rising 88 00:09:57.760 --> 00:10:01.760 prices in the orange markets and markets related to that. 89 00:10:01.760 --> 00:10:05.400 And these two things don't somehow offset each other. 90 00:10:05.400 --> 00:10:09.500 They would just put in motion a depressing effect along the lines of the argument they 91 00:10:09.500 --> 00:10:17.000 make about price stickiness and so on in the Apple market and the related markets. 92 00:10:17.000 --> 00:10:20.680 So then they say, well, okay, maybe that's not exactly what we have in mind. 93 00:10:20.680 --> 00:10:26.440 Maybe what the real argument is, is that it's just a balance of falling prices. 94 00:10:26.440 --> 00:10:34.160 So maybe what really happens is when we have money changing in demand, we get overall prices, 95 00:10:34.160 --> 00:10:39.060 We get more prices falling than we get rising, and that's what causes the problem, so we 96 00:10:39.060 --> 00:10:41.900 can leave this suggestion. 97 00:10:41.900 --> 00:10:46.800 But it seems to me that if that's correct, then the problem that they describe about 98 00:10:46.800 --> 00:10:53.640 price stickiness is actually worse, the narrower the scope of the decline in prices in the 99 00:10:53.640 --> 00:10:56.640 markets where the prices are declining. 100 00:10:56.640 --> 00:10:59.200 So let's just think through the adjustment process. 101 00:10:59.200 --> 00:11:04.940 This is the chain of falling prices if demand for something goes down. 102 00:11:04.940 --> 00:11:06.280 So we know what will happen, right? 103 00:11:06.280 --> 00:11:11.320 If we get falling demand for output, then revenue for selling the output has to go down. 104 00:11:11.320 --> 00:11:15.280 So we start, let's say, at point A, the midpoint of this original demand curve. 105 00:11:15.280 --> 00:11:20.220 The price is P. There's certain revenue, you know, P times the quantity. 106 00:11:20.220 --> 00:11:26.280 If demand goes to the left, then at this price, at P0, obviously the revenue will be much 107 00:11:26.280 --> 00:11:29.080 lower because the quantity is reduced. 108 00:11:29.080 --> 00:11:32.560 The people actually buy less, and so the revenue is reduced. 109 00:11:32.560 --> 00:11:36.240 And so with the entrepreneur, the entrepreneur's proper strategy, of course, is to lower his 110 00:11:36.240 --> 00:11:41.800 price, to re-maximize his revenue with the lower demand. 111 00:11:41.800 --> 00:11:45.600 But in any case, his revenue is lower, so that we know for sure. 112 00:11:45.600 --> 00:11:49.960 The lower revenue, then, requires him to reduce his demand for inputs. 113 00:11:49.960 --> 00:11:50.960 He doesn't have any choice, right? 114 00:11:50.960 --> 00:11:53.280 He doesn't have as much money as he did before. 115 00:11:53.280 --> 00:11:55.200 So his demand for inputs has to fall. 116 00:11:55.200 --> 00:11:59.320 It's not a question of, there's no other issue involved, right? 117 00:11:59.320 --> 00:12:02.320 He just has less money, and so it has to go down. 118 00:12:02.320 --> 00:12:07.440 And then the question becomes, well, when he lowers his demand for inputs, the negative 119 00:12:07.440 --> 00:12:15.360 effect on his ability to buy inputs in his production depends upon how narrow or how 120 00:12:15.360 --> 00:12:19.800 broad this effect of falling prices is. 121 00:12:19.800 --> 00:12:25.360 And my contention would be, if the fall in prices is just for his product, then he's 122 00:12:25.360 --> 00:12:30.560 in a much worse position than if it's very broad, just the opposite of what the monetary 123 00:12:30.560 --> 00:12:33.000 disequilibrium theorist would say. 124 00:12:33.000 --> 00:12:37.320 So if his demand goes down and now he tries to buy his inputs, but all the other entrepreneurs 125 00:12:37.320 --> 00:12:43.060 in this market, their demand for their products has stayed high, he will not be able to bid 126 00:12:43.060 --> 00:12:47.640 resources anymore, he can't pay lower prices and bid the resources he needs away from these 127 00:12:47.640 --> 00:12:51.400 These are the guys whose demand hasn't fallen, and so he's in a worse position. 128 00:12:51.400 --> 00:12:59.680 He has to cut his production, investors would disinvest in his production process. 129 00:12:59.680 --> 00:13:04.200 And whatever one might say about the prisoner's dilemma character of this situation for the 130 00:13:04.200 --> 00:13:10.080 entrepreneur, the outside investors who decapitalize him or capitalize him are not subject to this 131 00:13:10.080 --> 00:13:11.080 prisoner's dilemma. 132 00:13:11.080 --> 00:13:15.160 They're just going to pull their money out and his production will collapse. 133 00:13:15.160 --> 00:13:20.020 Now the broader the decline in prices, the better his position is. 134 00:13:20.020 --> 00:13:25.220 So if all the demand for all of his competitors in one market is falling, then when he goes 135 00:13:25.220 --> 00:13:30.880 to buy his inputs with his smaller demands, he'll be able to maintain his buying of these 136 00:13:30.880 --> 00:13:31.880 inputs. 137 00:13:31.880 --> 00:13:35.080 If the demands are falling throughout the economy, he's even in a better position because then 138 00:13:35.080 --> 00:13:40.160 he's buying inputs that are even more, I should say, less specific to his production process 139 00:13:40.160 --> 00:13:42.580 and he can still buy those too. 140 00:13:42.580 --> 00:13:48.460 So again, I don't think their argument is correct here. 141 00:13:48.460 --> 00:13:52.980 George Selgin again has this variation where he says entrepreneurs can't distinguish between 142 00:13:52.980 --> 00:13:57.620 declines in demand for his product alone and declines that are general because the demand 143 00:13:57.620 --> 00:14:00.440 for money has gone up, declines in demand for his product. 144 00:14:00.440 --> 00:14:08.080 But again, we just think about what happens to this guy, that doesn't matter, right? 145 00:14:08.080 --> 00:14:12.160 His best strategy when his demand goes down, for whatever reason, is to lower his price 146 00:14:12.160 --> 00:14:16.920 Price and re-maximizes revenue at the lower price. He has less revenue, his demand for 147 00:14:16.920 --> 00:14:21.920 inputs has to fall, and so economic calculation still works in this instance. 148 00:14:21.920 --> 00:14:28.280 Okay, now let me get to the very last point I want to make is on price stickiness, and 149 00:14:28.280 --> 00:14:33.280 again I'm not presenting a full argument here, I just mentioned I think monetary disequilibrium 150 00:14:33.280 --> 00:14:38.840 theory then at its core is just an argument about price stickiness. I don't think money 151 00:14:38.840 --> 00:14:42.000 Money has anything to do with it, or it's certainly monetary disequilibrium has nothing 152 00:14:42.000 --> 00:14:43.680 to do with it. 153 00:14:43.680 --> 00:14:47.840 So this is what Horowitz says about the speed of adjustment of prices, if they're unable 154 00:14:47.840 --> 00:14:53.120 to fall with significant speed, in the face of the excess demand, this creates the economic 155 00:14:53.120 --> 00:14:54.120 decline. 156 00:14:54.120 --> 00:14:59.760 But again, I would say first in response to this that if this were true, then this effect 157 00:14:59.760 --> 00:15:05.440 would occur if the demand for goods goes down too, and this has nothing to do with money. 158 00:15:05.440 --> 00:15:08.800 It just has to do with the stickiness of prices. 159 00:15:08.800 --> 00:15:12.720 The other thing to say about this is that the speed of adjustment of prices to changes 160 00:15:12.720 --> 00:15:17.280 in demands is an entrepreneurial choice, it's an entrepreneurial strategy. 161 00:15:17.280 --> 00:15:21.360 So some entrepreneurs are in markets where their customers want prices to change a lot, 162 00:15:21.360 --> 00:15:25.640 they want them to change instantaneously like in financial markets and then there are customers 163 00:15:25.640 --> 00:15:28.360 in other markets who don't want them to change. 164 00:15:28.360 --> 00:15:32.520 Every second as they're in retail stores as customers we don't want the prices to change 165 00:15:32.520 --> 00:15:38.080 and so the entrepreneurs to get the, you know, to maximize their profits and service our 166 00:15:38.080 --> 00:15:44.720 preferences leave prices the same. It's their policy to have the prices sticky. Wage contracts 167 00:15:44.720 --> 00:15:48.760 are the same, right? The entrepreneur forms a wage contract with the worker and price 168 00:15:48.760 --> 00:15:55.480 stickiness is built into this contract consciously by the two parties. The workers want fixed 169 00:15:55.480 --> 00:16:00.400 wages and the entrepreneur is willing to accept this uncertainty on the basis of this. 170 00:16:00.400 --> 00:16:05.600 And then the last thing I would say in response to the price stickiness is this is why entrepreneurs 171 00:16:05.600 --> 00:16:07.680 hold equity. 172 00:16:07.680 --> 00:16:12.520 They hold equity so that in the face of falling demand for their product, they can absorb 173 00:16:12.520 --> 00:16:17.200 some of the losses in the interim period when they're trying to figure out what's going 174 00:16:17.200 --> 00:16:18.200 on in the market. 175 00:16:18.200 --> 00:16:23.400 Is this a general demand, is this just specific to my good, how am I going to adjust to this? 176 00:16:23.400 --> 00:16:30.000 Well, they accommodate these sorts of things, again, in their normal business strategies. 177 00:16:30.000 --> 00:16:33.000 Okay, so at this point I'll stop.