WEBVTT NOTE Recession Economics and Non-Neutral Money 1 00:00:00.000 --> 00:00:07.780 My paper is not so much on money per se, but more business cycle type stuff, and the distinguishing 2 00:00:07.780 --> 00:00:14.080 characteristics that separate Austrian macroeconomics from the other types of macroeconomics can 3 00:00:14.080 --> 00:00:21.200 be found in one, heterogeneous capital, and two, the use of non-neutral money. 4 00:00:21.200 --> 00:00:28.080 And the Austrians have been very good when it comes to explaining the negative consequences 5 00:00:28.080 --> 00:00:30.080 of Monetary Expansion 6 00:00:30.080 --> 00:00:35.080 So, what does it do? Well, first of all, it erodes the purchasing power of each monetary unit. 7 00:00:35.080 --> 00:00:40.080 Monetary expansion changes the relationship between debtors and creditors. 8 00:00:40.080 --> 00:00:45.080 There's a signal extraction problem that's created. In other words, price signals are jammed. 9 00:00:45.080 --> 00:00:49.080 And if we're not careful, hyperinflation can come about. 10 00:00:49.080 --> 00:00:55.080 Now, most economists agree with these first four points, and here's where the Austrians add. 11 00:00:55.080 --> 00:01:02.080 There are non-neutral effects of monetary injections, and there are real wealth changes that occur because of it. 12 00:01:02.080 --> 00:01:06.080 And also, it can lead to a business cycle. 13 00:01:06.080 --> 00:01:14.080 So, the importance of non-neutral money is explained by Mises in his article, The Non-Neutrality of Money, 14 00:01:14.080 --> 00:01:21.080 which he presented in 1945 and also 1938, and is in Money Method and Market Process, and he says this. 15 00:01:21.080 --> 00:01:25.560 says, I wish to emphasize that in a living and changing world, in a world of action, 16 00:01:25.560 --> 00:01:32.360 there is no room left for a neutral money. Money is non-neutral or it does not exist. 17 00:01:32.360 --> 00:01:38.400 Well, that's a pretty powerful statement there. So I assume that this applies when the monetary 18 00:01:38.400 --> 00:01:44.800 supply expands and also with monetary contraction. We can't just, you know, look at it when it 19 00:01:44.800 --> 00:01:49.880 expands, but we also have to assume that money is non-neutral when it contracts. So when 20 00:01:49.880 --> 00:01:54.680 When we see monetary expansion, we see that money is injected at specific points in time 21 00:01:54.680 --> 00:01:58.760 and given to specific people and given to specific institutions. 22 00:01:58.760 --> 00:02:03.480 And when it does, each injection creates a unique pattern that's different each and 23 00:02:03.480 --> 00:02:04.480 every time. 24 00:02:04.480 --> 00:02:09.840 So if the Fed gave me ten million dollars today, I would spend it very differently than 25 00:02:09.840 --> 00:02:15.560 if they gave it to me a year ago or five years ago. 26 00:02:15.560 --> 00:02:17.760 And we see what happens as a result of this. 27 00:02:17.760 --> 00:02:22.160 The people who get the new money first win, and those people who get the new money last 28 00:02:22.160 --> 00:02:23.360 lose. 29 00:02:23.360 --> 00:02:27.360 And Austrian economics has talked about this over and over again. 30 00:02:27.360 --> 00:02:30.480 I think we've got that story down correctly. 31 00:02:30.480 --> 00:02:36.280 So then that brings us to the business cycle, and so we come to the upper turning point. 32 00:02:36.280 --> 00:02:38.440 What are the features of the upper turning point? 33 00:02:38.440 --> 00:02:43.080 Well, we see there's credit contraction, we see that there's rising interest rates, and 34 00:02:43.080 --> 00:02:45.560 we see that there's rising input prices. 35 00:02:45.560 --> 00:02:52.200 So the money supply can be contracted through exogenous forces where we have the central 36 00:02:52.200 --> 00:02:57.700 bank slamming on the monetary break, we can see it coming through endogenous forces where 37 00:02:57.700 --> 00:03:02.960 we have failures and bankruptcies of businesses and banks and that contracts the money supply, 38 00:03:02.960 --> 00:03:07.860 or most likely and usually the combination of the two forces. 39 00:03:07.860 --> 00:03:12.080 So let's look at the first one, the exogenous central bank. 40 00:03:12.080 --> 00:03:17.760 So what are the tools of the central bank? Well, we've got the central bank is able 41 00:03:17.760 --> 00:03:23.000 to set the required reserve ratio. It has the ability to encourage or discourage the 42 00:03:23.000 --> 00:03:27.800 banking system's acquisition of borrowed reserves. Now, a year ago, all I would say is it sets 43 00:03:27.800 --> 00:03:36.320 the discount rate, but they don't do that anymore. And then also the conduct of open 44 00:03:36.320 --> 00:03:40.960 market operations, the power to expand or contract the amount of non-borrowed reserves. 45 00:03:40.960 --> 00:03:47.200 So this is standard money and banking textbook stuff. It shouldn't surprise anyone. But the 46 00:03:47.200 --> 00:03:52.080 upshot of all of this that I want to draw your attention to is that for contractionary 47 00:03:52.080 --> 00:03:59.080 monetary policy, each tool results in the reduction of credit and loans. Now endogenous 48 00:04:00.400 --> 00:04:05.640 business failures are just basically businesses failing. And when they fail, they default 49 00:04:05.640 --> 00:04:11.120 on their loans, the banking system will face capital adequacy issues and therefore these 50 00:04:11.120 --> 00:04:15.760 banks are also going to fail. The collapse of a few banks could generate a contagion 51 00:04:15.760 --> 00:04:21.280 effect, it will cascade like dominoes, and many banks will implode, so the total amount 52 00:04:21.280 --> 00:04:26.800 of credit and loans shrinks. So what's the implication of this? Well, Mises is quite 53 00:04:26.800 --> 00:04:33.100 clear on this in Human Action, he says, the monetary contraction hurts all enterprises, 54 00:04:33.100 --> 00:04:40.420 Not only those which are doomed at any rate, but no less those whose businesses sound and 55 00:04:40.420 --> 00:04:43.200 could flourish if appropriate credit were available. 56 00:04:43.200 --> 00:04:47.480 As the outstanding debts are not paid back, banks lack the means to grant credits even 57 00:04:47.480 --> 00:04:49.420 to the most solid firms. 58 00:04:49.420 --> 00:04:53.860 The crisis becomes general and forces all branches of business and all firms to restrict 59 00:04:53.860 --> 00:04:55.540 the scope of their activities. 60 00:04:55.540 --> 00:05:01.260 But there is no means of avoiding these secondary consequences of the preceding boom. 61 00:05:01.260 --> 00:05:07.260 and this is what we call the secondary contraction, this is the thing that Hayek and Lionel Robbins 62 00:05:07.260 --> 00:05:09.340 were all upset about. 63 00:05:09.340 --> 00:05:15.380 So what then happens then after we turn that upper turning point, we start contracting? 64 00:05:15.380 --> 00:05:19.180 Well tracing the effects are not that easy, right? 65 00:05:19.180 --> 00:05:25.940 It's not just simply reversing the numbers or reversing the changes, it requires a separate 66 00:05:25.940 --> 00:05:31.940 step-by-step analytical process and and so we just can't just roll it back and 67 00:05:31.940 --> 00:05:37.140 and Mises has a wonderful quote and apparently Senholtz talked about it and 68 00:05:37.140 --> 00:05:40.940 then Larry Reed brought it up on the first day he said it's like when you 69 00:05:40.940 --> 00:05:44.100 run someone over with a car you're not going to help them out by throwing it in 70 00:05:44.100 --> 00:05:50.100 reverse and running back over them so we have to we have to analyze what happens 71 00:05:50.100 --> 00:05:55.780 here and Rothbard then says well the crisis this isivid man economy and states 72 00:05:55.780 --> 00:06:01.340 The crisis is often marked not only by a halt to credit expansion, but an actual deflation, 73 00:06:01.340 --> 00:06:03.740 a contraction of the money supply. 74 00:06:03.740 --> 00:06:07.420 The deflation causes a further decline in prices. 75 00:06:07.420 --> 00:06:12.020 Any increase in demand for money will speed up adjustment to the lower prices. 76 00:06:12.020 --> 00:06:17.420 Now, while in general it may be true that these prices fall, we cannot make the leap 77 00:06:17.420 --> 00:06:23.280 to say that all prices fall, because non-neutral money has to work both ways. 78 00:06:23.280 --> 00:06:29.280 The prices are the signals of relative scarcity ratios and any falsifying or jamming of the 79 00:06:29.280 --> 00:06:35.880 price signal creates market misallocations. Some of these market misallocations will manifest 80 00:06:35.880 --> 00:06:42.060 as projects that use capital equipment and as such should also be termed malinvestment. 81 00:06:42.060 --> 00:06:47.400 If you look at some businesses, they're counter-cyclical. Like what? Mount Olive College. What are we 82 00:06:47.400 --> 00:06:51.800 doing? We're getting big enrollments now because people are losing their jobs, they're looking 83 00:06:51.800 --> 00:06:56.440 for something else, and we're going in building new dorms, and we're building this, we're 84 00:06:56.440 --> 00:07:07.560 building that. That's malinvestment. It's okay, but no one on the faculty will watch 85 00:07:07.560 --> 00:07:20.760 this here. I hope. It's on YouTube, right? Not yet. Back to Rothbard. Rothbard will always 86 00:07:20.760 --> 00:07:50.760 So what does Rothbard say? He says furthermore deflation will haste an adjustment in yet another way. For the accounting error of the inflation here is here reversed and the businessmen will think their losses are more and profits less than they really are. Hence they will save more than they would have with correct accounting and the increased saving will speed adjustment by supplying some of the needed deficiency of savings. Now notice that a systemic entrepreneurial error emerges 87 00:07:50.760 --> 00:07:57.320 emerges from the secondary monetary contraction. Rothbard argues that the adjustment caused 88 00:07:57.320 --> 00:08:02.960 by the incorrect accounting leads to a faster adjustment with an increase in savings. While 89 00:08:02.960 --> 00:08:10.880 his analysis may be correct, this increase in savings or forced savings is also a misallocation 90 00:08:10.880 --> 00:08:19.080 of resources. The consequence of this incorrect accounting is that the economy overly contracts. 91 00:08:19.080 --> 00:08:29.080 It seems that economists and policy-setters face a trade-off between the length of the recession and its depth. 92 00:08:29.080 --> 00:08:33.080 In a recession, the central bank has three courses to choose from. 93 00:08:33.080 --> 00:08:38.080 It can do nothing and not interfere in the liquidation process. 94 00:08:38.080 --> 00:08:44.080 It can actively contract the money supply in the hopes of accelerating the correction of the past malinvestments. 95 00:08:44.080 --> 00:08:51.080 and, finally, it can engage in expansionary monetary policy to counteract the deflation of the money supply and prices. 96 00:08:51.080 --> 00:09:00.080 So, it can either do nothing, it can bring the money in, or it can try to stop the deflation by pumping more money out. 97 00:09:00.080 --> 00:09:07.080 So, non-interference, or maybe technically it should be no further interference, by the central bank. 98 00:09:07.080 --> 00:09:13.920 of the Central Bank. The recessions are processes of liquidation that clean out the malinvestments 99 00:09:13.920 --> 00:09:19.280 that were built up during the artificial boom. During this phase of the business cycle, credit 100 00:09:19.280 --> 00:09:25.760 is constricted and profit margins fall. In a recession now, people are hurt, real people 101 00:09:25.760 --> 00:09:30.840 we're talking about, more than they would be if there was no secondary contraction. 102 00:09:30.840 --> 00:09:36.200 So the secondary contraction is this extra pain. And it's something that we need to 103 00:09:36.200 --> 00:09:42.320 to keep in mind, especially when we're talking to people beyond just academics, because they 104 00:09:42.320 --> 00:09:47.980 not just think, they feel, and they go with their gut, they go with their heart. And some 105 00:09:47.980 --> 00:09:53.980 entrepreneurs whose businesses would not have normally failed, do fail, due to the larger 106 00:09:53.980 --> 00:10:00.480 macroeconomic situation, right? The big wave just knocks out a whole bunch of businesses. 107 00:10:00.480 --> 00:10:05.440 So this secondary contraction is what caused Hayek and Robbins to lament that they did 108 00:10:05.440 --> 00:10:09.680 did not advocate a policy of monetary expansion. 109 00:10:09.680 --> 00:10:15.440 The transformation of savings into new capital and realignment of production methods to this 110 00:10:15.440 --> 00:10:21.560 new reality is a slow process because we've got to throw stuff away, we've got to change 111 00:10:21.560 --> 00:10:26.720 the structure of production and it's not going to be a quick fix. 112 00:10:26.720 --> 00:10:32.680 So during this time, hurt and hardship are endured by real, living people. 113 00:10:32.680 --> 00:10:39.680 The failure to sufficiently emote on this point has caused the free market economist to be portrayed as without a heart. 114 00:10:39.680 --> 00:10:43.680 Such portrayals do not win over the setters of policy. 115 00:10:43.680 --> 00:10:49.680 Thus the economist is asked for a do-something policy. 116 00:10:49.680 --> 00:10:53.680 So, what do we do? 117 00:10:53.680 --> 00:11:01.680 Well, let's suppose that we encourage the central bank to deflate, to contract the money supply 118 00:11:01.680 --> 00:11:07.180 in the hopes of accelerating the end of the downturn, right? You want it short and sharp. 119 00:11:07.180 --> 00:11:12.800 Now, the deflation choice might be something that a reader of Rothbard, Salerno, and Holzman 120 00:11:12.800 --> 00:11:18.580 might contemplate doing. Well, now why is that? Well, although none of the authors advocate 121 00:11:18.580 --> 00:11:22.460 a policy of monetary contraction in the middle of a recession, I talked to Guido before this, 122 00:11:22.460 --> 00:11:27.460 he said, no, I don't do that, or actually in German, you know, no, I don't do that. 123 00:11:27.460 --> 00:11:35.700 Such a policy may be inferred from statements claiming that, quote, no harm will be done 124 00:11:35.700 --> 00:11:41.980 by deflation. It is benign. It benefits taxpayers through the process of rabatrage. There is 125 00:11:41.980 --> 00:11:47.540 no reason why this redistribution from deflation should have negative consequences for overall 126 00:11:47.540 --> 00:11:52.860 production. Bankruptcies do not affect the real wealth of the nation, and deflation appears 127 00:11:52.860 --> 00:11:57.180 as a great harbinger of liberty. Now, why someone might infer that deflation is a good 128 00:11:57.180 --> 00:12:09.180 Rothbard and Holzman both recognize that there will be redistributional effects generated 129 00:12:09.180 --> 00:12:15.980 from monetary contraction. However, I believe they both consider the benefits to outweigh 130 00:12:15.980 --> 00:12:24.740 the negatives. Setting aside issues of justice and comeuppance, Rothbard is taking a normative 131 00:12:24.740 --> 00:12:29.700 position that cannot be supported by theory. His position is that the harm to those caught 132 00:12:29.700 --> 00:12:35.540 up in the overshooting of monetary and economic contraction is outweighed by the increased 133 00:12:35.540 --> 00:12:42.460 speed by which the economy bottoms out and begins recovery. While one may personally 134 00:12:42.460 --> 00:12:47.620 agree with this trade-off, shorter and deeper versus longer and shallower, Rothbard cannot 135 00:12:47.620 --> 00:12:54.380 make such an interpersonal utility comparison. And when Holzman dismisses the redistributional 136 00:12:54.380 --> 00:12:59.380 by arguing that they cannot be avoided, seems to be ducking the issue. 137 00:12:59.380 --> 00:13:05.380 These redistributions would create malinvestments, which would need to be liquidated in the future date. 138 00:13:05.380 --> 00:13:14.380 When I was driving over here, and we were just north of Charlotte, we got stop and stop traffic. 139 00:13:14.380 --> 00:13:17.380 Not stop and go, but stop and stop, and we were like, what's going on? 140 00:13:17.380 --> 00:13:23.380 And eventually when we got to the end of whatever the problem was, there was a sign that said, merge left. 141 00:13:23.380 --> 00:13:30.380 Road Construction Ahead 142 00:13:53.380 --> 00:14:05.380 If policy-setters were to follow this advice and direct the central bank to actively engage in a policy of monetary contraction, how would it be accomplished such that only the funding of malinvestment was withdrawn? 143 00:14:05.380 --> 00:14:11.380 Nobody knows. How do you do that? Nobody knows. And obviously, this is an impossible task. 144 00:14:11.380 --> 00:14:19.380 With redistributional effects present, pulling money out of the banking sector would make them the biggest losers. Ha-ha! Take that, banks! 145 00:14:19.380 --> 00:14:24.340 But what needs to be liquidated is not redistributed wealth, but the malinvestments that were built 146 00:14:24.340 --> 00:14:26.780 up during the artificial boom. 147 00:14:26.780 --> 00:14:32.360 If we consider the banking system is in large part a pass-through of new funds, then redistributing 148 00:14:32.360 --> 00:14:36.300 wealth away from the banking industry will not liquidate the malinvestment. 149 00:14:36.300 --> 00:14:40.580 Instead, the distortionary effects are compounded. 150 00:14:40.580 --> 00:14:45.620 Prices are being falsified, resources are being misallocated, and capital budgetary 151 00:14:45.620 --> 00:14:51.700 Monetary expenditures are enacted on the basis of these false prices. 152 00:14:51.700 --> 00:14:52.700 So then what? 153 00:14:52.700 --> 00:14:56.280 Well, we could encourage the central bank to reflate. 154 00:14:56.280 --> 00:15:03.340 So Solzhen in less than zero and Hayek in 75 and Robbins in 71 support the productivity 155 00:15:03.340 --> 00:15:06.100 norm as a standard for the conduct of monetary policy. 156 00:15:06.100 --> 00:15:12.620 As a policy goal, they wish to keep nominal income constant, thus when people decide to 157 00:15:12.620 --> 00:15:16.860 To hold on to more cash balances where we see a drop in V, there should be an expansion 158 00:15:16.860 --> 00:15:21.020 of the money supply to offset this contraction. 159 00:15:21.020 --> 00:15:25.640 To accept this policy recommendation, the question of what would it take to nullify 160 00:15:25.640 --> 00:15:29.820 the effects of a decrease in V, well that needs to be answered. 161 00:15:29.820 --> 00:15:33.660 When people hold on to more cash balances, the nominal money supply contracts and there 162 00:15:33.660 --> 00:15:36.820 is a decrease in demand deposits and less credit. 163 00:15:36.820 --> 00:15:42.580 The money that is injected into the economy must go to only those enterprises that are 164 00:15:42.580 --> 00:15:49.580 are contracting from the secondary contraction, but not to those malinvestments that were built up in the initial credit expansion. 165 00:15:49.580 --> 00:15:51.580 Now how do we do that? 166 00:15:51.580 --> 00:15:54.580 Well, I think meeting such a condition is, of course, impossible. 167 00:15:54.580 --> 00:16:02.580 There's no method by which one can recognize ex-ante which projects are malinvestment and which projects are not. 168 00:16:02.580 --> 00:16:08.580 The expansion of the money supply, regardless of intent, has the same six consequences outlined above, 169 00:16:08.580 --> 00:16:13.580 and it does not matter whether the economy is moderately growing or in recession. 170 00:16:13.580 --> 00:16:17.580 The trade-off between depth and duration ends up being a false one. 171 00:16:17.580 --> 00:16:21.580 The malinvestments will eventually need to be liquidated. 172 00:16:21.580 --> 00:16:26.580 Each injection then causes additional misallocations of resources, 173 00:16:26.580 --> 00:16:32.580 builds up malinvestments and prolongs the suffering of those in the economy. 174 00:16:32.580 --> 00:16:34.580 So what do we do? 175 00:16:34.580 --> 00:16:39.460 Well, the central bank policy-setters have three options open to them. 176 00:16:39.460 --> 00:16:43.900 The option of non-interference leads to a secondary economic contraction, and that's 177 00:16:43.900 --> 00:16:48.540 unfair and unjust to those living in the midst of a recession. 178 00:16:48.540 --> 00:16:54.580 The policy of monetary contraction overrules market preferences and deepens the secondary 179 00:16:54.580 --> 00:16:57.900 contraction in the hope that it will be over more quickly. 180 00:16:57.900 --> 00:17:02.500 While the theory does point to the possibility that a recession may end sooner, it's not 181 00:17:02.500 --> 00:17:03.500 guaranteed. 182 00:17:03.500 --> 00:17:07.420 is certain that accelerating the secondary contraction will lead to more significant 183 00:17:07.420 --> 00:17:11.140 overshooting and thus economic hardships. 184 00:17:11.140 --> 00:17:16.060 Then the third policy then, choice of monetary expansion, attempts to avoid the pain of economic 185 00:17:16.060 --> 00:17:20.700 contraction, but it also avoids solving the problem of malinvested capital equipment and 186 00:17:20.700 --> 00:17:25.580 misallocated production structures. At best it delays the solution, at worst it makes 187 00:17:25.580 --> 00:17:32.100 the future economic hole deeper. Thus we're back to the policy of non-interference. It's 188 00:17:32.100 --> 00:17:37.760 It's a terrible policy for the central bank to take. However, it's better than its alternatives. 189 00:17:37.760 --> 00:17:41.940 It should be remembered that the hardship endured under a non-interference policy does not stem 190 00:17:41.940 --> 00:17:46.820 from the policy itself, but from the fact that we're in a recession. When malinvestments 191 00:17:46.820 --> 00:17:52.020 are built up during the previous expansionary monetary policies, recessions are the necessary 192 00:17:52.020 --> 00:17:57.640 consequence. It's like going to the dentist. Having a cavity sucks, it's not fun, but you 193 00:17:57.640 --> 00:18:04.640 We've got to drill it out. Recessions are terrible economic events, but are necessary for the overall health of the economy.