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Source link: http://archive.mises.org/18047/monetary-disequilibrium/

Monetary Disequilibrium

August 11, 2011 by

Some time ago I wrote a short review of free banking theory, which is now lost.  While I expressed agreement with the microeconomic theory of free banking as presented in George Selgin’s The Theory of Free Banking, I disagreed with the macroeconomic integration of monetary disequilibrium theory.  I recently expanded this part of my argument into a short paper (5-6 pages; ~2,400 words),

Here is the abstract,

This paper is a short argument as to why the macroeconomic theory of monetary disequilibrium is untenable and why free bankers should shed it from their theoretical arsenal. Monetary equilibrium cannot achieve price stabilization, nor is deflation resulting from an excess demand for money harmful. These should not be considered macroeconomic goals or advantages of a free banking system.

If interested, you can download the paper off SSRN.

{ 42 comments }

Ivan Georgiev August 11, 2011 at 1:02 pm

“Some time ago I wrote a short review of free banking theory, which is now lost”

Do you mean the review you posted on you blog? I believe I can access it through my Google Reader, do you want it?

Regarding the so called monetary disequilibrium which is not itself an economic problem existing in the free market, but rather a justification for government interference made by free bankers: no such thing as monetary disequilibrium exists.

Jonathan M.F. Catalán August 11, 2011 at 1:25 pm

Thanks for the PDF converter link — I had to convert from .docx to open office to pdf.

I don’t know if we can say that monetary disequilibrium doesn’t “exist”. The demand for and supply of money are real concepts, and it is true that money has no market of its own. The only thing we should doubt is the belief that maintaining monetary equilibrium is the only way to avoid discoordination (or, even if monetary equilibrium can help coordinate the pricing process).

Ivan Georgiev August 11, 2011 at 1:04 pm

I am sorry for the second post but Jonathan I recommend you this site http://www.freepdfconvert.com/ when you want to convert to pdf.

fundamentalist August 11, 2011 at 1:08 pm

Nice paper! Thanks! Enjoyed it very much.

My problem with monetary equilibrium, in addition to yours, is the implied assumption that an increased demand for money is a random event, like a thunderstorm. It’s not. People don’t just wake up in the morning and decide they will hold more cash. The desire for more cash holdings follows a crisis, such as a job loss.

On a macro basis, the crisis is usually the beginning of a depression. So if you want to deal with sudden changes in the demand for money, deal with the cause, not the symptom.

Also, a sudden demand for cash may actually stimulate the economy rather than retard it as the monetary equilibrium proponents argue. The demand for cash is the same thing as a reduction in demand for goods, but not all goods. The demand for cash is the reduction in demand for consumer goods, not capital goods.

And according to micro econ 101 and Hayek’s Ricardo Effect, how do consumer goods makers respond to a fall in demand? They demand more capital goods that reduce the cost of their labor. So the reduction in demand for consumer goods will trigger an increase in demand for capital goods.

Monetary equilibriumationismas commit the Keynesian fallacy of aggregation.

Rob Read August 11, 2011 at 3:05 pm

On the subject of “Price Discoordination and Entrepreneurship”: Isn’t the comparison with the injection of fiduciary media more comparable to a situation of monetary disequilibrium caused by a decreased demand for money?

If my understanding of the theory is correct then :

Under 100% reserve banking this would involve reduced cash balances and some of the decrease would go via the loan market. This would lower the interest rate with no change in time preference and cause a distortion.

Under an FRB system the decreased demand would send signals that would lead to a counteracting reduction in loans that would keep the IR aligned with the natural rate.

Jonathan M.F. Catalán August 11, 2011 at 3:28 pm

That’s not what I meant. An excess demand for money is considered the opposite of an increase in fiduciary media (and increase in the supply of money). My point is that in order for it to be the opposite the reduction in the money supply would have to be exogenous to the preferences of the consumers.

Rob Read August 11, 2011 at 3:58 pm

I’m not sure of the relevance of the changes being “exogenous to the preferences of the consumers” here.

In any situations where the bank rate deviates from the natural rates there will be distortions to the structure of production. In the case of an increase in fiduciary media the distortion takes place because when the new money appears the interest rate will decline below the equilibrium level until the overall price level adjusts,

In the case of increased demand for money then under 100% reserve then (again until price adjusts to the new level) the interest rate will be above the natural level and some businesses that would be viable in equilibrium will be liquidated, like the ATBC in reverse.

DD5 August 11, 2011 at 5:07 pm

The bank rate always deviates from the natural rate. The natural rate is just a goal or target representing hypothetical time preference schedules. So merely pointing out that something causes a deviation from equilibrium in your static analysis cannot possibly be an argument for any type of distortion, for then, we will all have to concede that any change in supply and demand on the free market leads to distortions, which would be absolute nonsense.

Rob Read August 11, 2011 at 5:21 pm

You are correct. Sometimes the deviations from equilibrium are significant enough to warrant investigation especially if they have a systematic cause outside of changes in consumer preference. I think boom/bust cycles caused by increased fiduciary media , and recessions caused by increased demand for money are both in this category and hence this thread.

DD5 August 12, 2011 at 8:11 am

If you want to selectively call some adjustments of the market in response to changes in voluntary preferences a “recession”, you are free to do so, but then you are simply engaged in semantic trickery to equate that with any affects fiduciary media have on the market. Fiduciary media temporarily distort monetary calculations so as to make entrepreneurial decisions not to be aligned with consumer demand. A general increase in demand for money sets off an adjustment process that IS aligned with the voluntary demands of consumer preference. Anybody who wishes to hold more money does so instantly and anyone wishing to rid of his money does so also instantly. The adjustment process is gradual and incremental of course, but that’s because the affects of changes in demand for money themselves are gradual. They don’t affect all participants at the same time. But there is no distortion in monetary calculations. Changes in prices follow the pattern of adjustments. Sure, it is not easy to always guess correctly what these changes really mean. But this is because prices by themselves do not reveal the future state of the market. Really the equivocation of fiduciary media with changes in demand for money reveal a lack of proper price theory in my opinion.

Rob Read August 12, 2011 at 10:24 am

I am very new to this debate and have observed that much of the disagreement comes from a difference in the definition of savings. As Jonathon points out FRBers include cash balances as savings and 100ers do not. Of course this is not just a matter of definitive as FRBers believe that it is valid to lend out cash balances for profit while 100% do not.

Many defenders of 100% reserve banking appear to hold the view that fiduciary media in any circumstances will distort the market irrespective of whether it comes from loaning out of cash-balances or from central-bank pumping. (It seems likely but it is not clear from this post that this is your view).

I have yet to see a sound theoretical justification of this position.

DD5 August 12, 2011 at 2:13 pm

This has nothing to do with definitions. You can’t define your way out of problems. You can consider a cash balance as savings if you like, however, this would just mean that one is investing in money for the time being, and not in direct investments. Money has its own yield and if one is “saving” money, then one cannot lend it out at the same time without causing some unintended microeconomics effects. This would mean that the same amount of money is being used twice (or multiple times) simultaneously, which is a praxeological impossibility. There are those who deny that money has a yield of its own, and therefore run into no problem declaring the efficiency of lending out money sitting idle in some bank account. The “free bankers” however, do acknowledge the yield of money, but then are forced to ignore key praxeolgoical insights in both contract theory, and microeconomics effects in order to make this claim. Their entire economic theory rests on pure aggregate macro-economics not much different from your typical Monetarism. MET is in fact a product of Monetarism. Not Austrian/Misesian monetary theory.

Rob Read August 12, 2011 at 8:32 pm

As long as a bank manages its reserves and lending strategy appropriately I do not see any “unintended microeconomics effects of lending out cash balances” .

Rob Read August 11, 2011 at 5:41 pm

I just thought a bit more about the “exogenous to the preferences of the consumers” theme. In the FRB framework an increased demand for cash holding signals in effect an increase in desire to provide money to lend. If (as would be the case in a 100% reserve situation) the bank does not respond by actually increasing lending then (FRBers would argue) the distortion is in fact caused by a factor “exogenous to the preferences of the consumers”

Rob Read August 12, 2011 at 3:26 pm

I think there is a difference between changes in the prices of goods due to changes in consumer preference (that you are describing) and a change in the price of money due to changes in its demand (that Selgin describes) .

Jonathan M.F. Catalán August 12, 2011 at 3:34 pm

Changes in the demand for money is a change in consumer preference. Money doesn’t have a price of its own. The value of money is a relation with the value of the good you want to exchange it for. Changes in consumer preference between goods will also change the value of money in respect to those goods.

Jonathan M.F. Catalán August 11, 2011 at 6:37 pm

The natural rate of interest is a reflection of consumer time preference. Changes in supply and demand for money that are caused by changes in consumer preference shouldn’t cause deviation between the market and the natural rate of interest.

In the case of full reserves, I’m not sure an increase in the demand for money would cause that. Let’s assume that an increase in demand for money is the same as an increase in savings, which is the free banker’s argument (and I don’t question in my paper — because, I agree with it). So, there’s an increase in the demand for money and the natural rate of interest lowers. There is not an increase in the supply of loanable funds (fiduciary injection), and so the market rate of interest remains the same. The market rate of interest remains the same; the degree of capital intensity reflects that rate of interest, not the new rate of interest. There’s no “ABCT in reverse”; the degree of capital intensity simply doesn’t increase.

Rob Read August 11, 2011 at 7:41 pm

I thought this through a bit more and have revised my views on what happens in the 100% reserve case.

For FRB: Assuming that the addition to cash balances comes at least partially from consumption spending then as this money (treated by FRBs as savings) is lent out then interest rates will fall and the length of the structure of production will increase. Relative prices will change but no absolute change in PPM will be needed.

Under 100% reserve: Assuming that the addition to cash balances comes at least partially from capital spending then TP will rise. As none of the additional cash balances will be lent out bank rates will stay the same. Until we reach the new equilibrium (just as in ATBC) we have interest rates below natural rate. In addition, to get back to equilibrium both relative prices and PPM have to change. Plus overall investment in the economy is at a lower level in that final equilibrium.

(I suspect there may be a flaw in my logic on the 100% reserve case – please let me know)

Jonathan M.F. Catalán August 11, 2011 at 8:03 pm

Fwiw, even if we accept the free bankers’ premise on savings and growth, whatever loss of growth there may be is probably negligible. The demand for money doesn’t really fluctuate dramatically, except during cyclical downturns, and we know that the original problem in the business cycle is insufficient savings — so, an increase in demand for money may be a positive force during a cyclical downturn.

Rob Read August 11, 2011 at 10:40 pm

RE: Jonathan M.F. Catalán August 11, 2011 at 8:03 pm

Assuming we are now in a situation of monetary disequilibrium caused by increased demand for cash holding then I’m not sure the loss of growth is negligible even if the original problem was lack of savings to sustain the boom.

Jonathan M.F. Catalán August 11, 2011 at 11:02 pm

Rob,

Our situation is a result of different forms of deflation. The industrial fluctuation was caused by an oversupply of fiduciary media by our central banking system (central bank + banks part of the system). When it became clear that there was an insufficient amount of capital goods, due to a re-pricing of these capital goods relative to each other and to the final consumer good, these bad investments had to be liquidated. This means that loans which were made to fund these investments were no longer repayable — there was a massive credit contraction of this type. Banks that were now facing a massive reduction in expected income now had to increase capital requirements as a means of dealing with the tide of defaults, and this is the second form of credit contraction. Finally, people increased their demand for money.

If the original problem is a lack of sufficient savings, a rising demand for money during periods of credit contraction represents a positive force — it increases the pool of savings. It also, effectively, helps cut the credit contraction cut short, since these savings allow for less liquidation of malinvestment and thus a faster return to stability.

In my opinion, fiduciary expansion during periods of credit contraction is counterproductive. The fact is that the widespread credit default forces a readjustment of prices, so fiduciary expansion to combat this readjustment is absurd (and, absurd also on the fact that you can’t guarantee that the allocation of currency will be the same as it was prior to the fluctuation). Also, I don’t think a free banking system would be able to expand the money supply during periods of credit contraction, because their ability to extend loans is obviously limited by the fact that they are facing widespread default on prior loans — they are not stable enough to issue more liabilities.

Rob Read August 12, 2011 at 1:55 am

Thanks for detailed reply !

I think your first paragraph is a great explanation of what actually happened.

However I don’t think it was a lack of savings that caused the crash – it was that the additional money flowing through the banks caused the interest rate to lower and distort investment patterns (a crash can occur no matter what the level of savings given a central banks policy to drive down rates). I need to research more the “pool of savings” argument you advance as I don’t currently get how a larger pool of money savings in and of itself will speed a return to stability.

In a free banking system one can assume that the effects of business cycle will be eliminated or at least much reduced. However sudden changes in demand for money may still occur for other reasons. In this environment, if profit-maximizing FRBs can then play a role in stabilizing the money-supply by acting as intermediaries between holders of cash-balances and business then this will help move the economy towards the new equilibrium.

I do however share your concerns that it is not clear how well placed they may in fact be to do this if the banks themselves are weakened by defaults etc during the period of increased money demand.

Also

Jonathan M.F. Catalán August 12, 2011 at 10:36 am

What causes industrial fluctuations is an artificially low rate of interest. But, what this does is that it increases demand in the capital goods industry. This creates false profit signals, because an increase in demand for goods of the second-order will, in turn, increase demand for goods of the third-order. This continues, ideally, until profits become intertemporally uniform. So, production begins to take shape around these changing profit signals, and it becomes more capital intensive.

What makes it malinvestment is that the price of capital-goods does not reflect the real underlying intertemporal preferences of the consumer. There was no real increase in savings (which lowers the rate of interest). Thus, the structure of production becomes more capital intensive without the necessary increase in savings (capital goods).

See “The Foremost Austrian Contribution to Economic Science“; specifically, that under the heading “Hayek’s Contribution”.

Rob Read August 12, 2011 at 1:14 pm

Thanks.

That article explains very well the structure of production and the business cycle but I don’t see anything there that explains why increased cash holding ( “a greater pool of savings” ) helps in the recovery.

I think this is an important point in regards to your paper on FRB and monetary disequilibrium. In theory in an FRB system banks will be intermediaries channeling savings held in cash balances into loans. This will keep the money supply, the interest rate and the process level aligned and keep the economy closer to equilibrium through time.

Is there a reason I am missing why increased cash balances and falling prices are an essential part of a recovery process from the type of “credit contraction” you described in your earlier post ?

Jonathan M.F. Catalán August 12, 2011 at 1:17 pm

If the problem is a lack of savings, then how can an increase in savings hurt?

Rob Read August 12, 2011 at 1:47 pm

It could potentially cause a situation of monetary disequilibrium and a short-term fall in TP (assuming the change in demand is temporary) if the savings are not channeled into loans.

Jonathan M.F. Catalán August 12, 2011 at 1:54 pm

But the depression was caused by a discoordination between investment and time preference (i.e. investment that assumed a lower time preference). An increase in time preference could only mitigate the negative consequences of this discoordination. As for monetary disequilibrium, I’m not sure what it matters given what I write in the linked paper and what we’re discussing here (and, again, I stress the fact that the depression was caused by an increase in the supply of money, so we’re discussing more than just a reactionary increase in the demand for money — both the demand and supply curves would be moving, in this case).

Rob Read August 12, 2011 at 2:51 pm

In regards to your paper I would like to quote at length from George Selgin:

“Any departure from monetary equilibrium has disruptive consequences. Consider what happens when the supply of money fails to increase in response to an increase in demand for money on the part of wage earners. The wage earners attempt to increase their money balances by reducing their purchases of consumer products, but there is no offsetting increase in demand for products due to increased, bank-financed expenditures. Therefore, the reduction in demand leads to an accumulation of goods inventories. Businesses’ nominal revenues become deficient relative to outlays for factors of production—the difference representing money that wage earners have withdrawn from circulation. Since each entrepreneur notices a deficiency of his own revenues only, without perceiving it as a mere prelude to a general fall in prices including factor prices, he views the falling off of demand for his product as symbolizing (at least in part) a lasting decline in the profitability of his particular line of business. If all entrepreneurs reduce their output, the result is a general downturn, which ends only once a general fall in prices raises the real supply of money to its desired level.
As was said previously, such a crisis can occur only if banks fail to respond adequately to a general increase in the demand for inside money. The crisis involves a deflationary Wicksellian process during which bank rates of interest are temporarily above their natural level. This is opposite the inflationary Wicksellian process, with bank rates below the equilibrium or natural rate of interest, that economists of the Austrian school traditionally emphasize. Nevertheless deflation (resulting from unaccommodated excess demand for inside money) has been an important factor in historical business cycles, and a banking system that promotes deflation disrupts economic activity just as surely as one that promotes inflation, although the exact nature of the disruption differs in each case.”

Of course in time the processes you describe in your paper will come into play and things will get back into equilibrium but (and this is the key point) at a greater economic costs than if FRBs expand lending in this kind of situation.

Jonathan M.F. Catalán August 12, 2011 at 3:01 pm

Rob,

What you quote is addressed in the paper; in fact, the entire paper is my rationale behind my rejection of the notion that a “departure from monetary equilibrium has disruptive consequences.”

The nature of money and preferences is that demand for different goods rises and falls with changes in preferences. This is an aspect of the economy that the entrepreneur has to constantly deal with; it is the entrepreneur’s job to best predict changes in consumer preference. A rise in the demand for money will cause those consumers who are holding greater cash balances to reduce demand for certain goods; entrepreneurs will have to predict that change in consumer preference, just like they have to do with any.

The reason why monetary disequilibrium theorists consider monetary disequilibrium a problem, as I explain in my paper, is because they consider prices to be sticky. But, like I write in my paper, sticky prices are a “problem” whether or not there is monetary disequilibrium — it’s a reality that is a corollary from the use of money in an economy. But, if entrepreneurs can deal with sticky prices during changes in preferences between different goods, they can also deal with sticky prices during changes in preferences between different goods and the demand to hold greater cash balances.

In regards to Selgin’s discussion of interest rates, we’ve been over this before.

Rob Read August 12, 2011 at 4:01 pm

In my view money has a price in terms of each good it is exchanged for It is because it is one half of almost every transaction that the price of money is so key to economic theory The consequences of a change in the value of money (which I agree is still down to consumer preference) tends to be more complex than changes in the value of other goods – especially if the change is relatively large and relatively fast.

DD5 August 11, 2011 at 4:49 pm

No, maybe you meant an increase in demand for money is the opposite of …. Not excess demand for money.

Jonathan M.F. Catalán August 11, 2011 at 6:33 pm

I’m not sure what you’re trying to say. I mean an excess demand for money; or an increase in the demand for money without an equal increase in the supply of money.

DD5 August 12, 2011 at 7:50 am

Then what you said makes no sense. A shortage for money is the opposite of an increase in the supply of money. That’s what you basically said. The opposite of an increase in the supply of money is a decrease in the supply of money, so according to your logic: excess demand for money=decrease in the supply of money, which is nonsense.

Jonathan M.F. Catalán August 12, 2011 at 10:31 am

It’s a decrease in the supply of money in circulation; if it wasn’t then prices wouldn’t adjust downwards.

DD5 August 12, 2011 at 2:02 pm

You’re equating any increase in the demand for money with a shortage of some sort for money. It’s a question begging assertion, which you or anybody has yet to prove. And it also doesn’t sit well with the general Misesian understanding that any increases or decreases in the supply of money confer no social benefit both in the short run and in the long run: “The quantity of money is irrelevant for the benefits derived from its use, in the long run and in the short run.” (Mises, HA, p-421)

Jonathan M.F. Catalán August 12, 2011 at 2:11 pm

Let’s be clear that I’m not saying that an excess demand for money is bad; my entire paper is on why an excess demand for money doesn’t justify an increase in the supply of fiduciary media. And, as I state in my above discussion with Rob Read, an increase in the demand for money can have an important social benefit.

The point that Rob originally brought up is a misunderstanding of what I said. He thought I equated an excess demand for money with an oversupply of fiduciary media. I was actually criticizing the notion that an excess demand for money could, in a sense, be considered the opposite of this excess of fiduciary media. Here, by excess of fiduciary media I mean an increase in the supply of fiduciary media by part of the banks (what causes intertemporal discoordination). I said that an excess demand for money is not the opposite; the opposite would be a purposeful credit contraction by part of the banking system.

DD5 August 12, 2011 at 4:24 pm

Yes, it’s perfectly clear you’re not saying that an excess demand for money is bad. However, you’re still making the assertion that an increase in demand for money results in a shortage. But there can be no shortages for money if you agree with the claim that unlike all other goods, increasing (or decreasing) the supply of money confers no social benefit in the short run and long run. This view cannot be reconciled with the concept of “excess demand for money” or shortage for money in plain English. It is in this respect that money is different from all other goods, and it is the error of all MET theorists to ignore this major difference. It is precisely because there is never any shortage of money, that it continues to function reliably as before even when the demand for money change continuously. It is not that the pricing system still works to alleviate the alleged shortage for money (excess demand), as you had suggested. This line of argument will lead you to circular reasoning. It is that there is no such problem of excess demand for money in the first place, and that’s why MET theorists are just blowing hot air on a problem that does not exist.

Jonathan M.F. Catalán August 12, 2011 at 4:39 pm

You’re getting too caught up in the terminology. An “excess demand for money” only refers to an increase in the demand for money without an equal increase in the supply of money. Whether you think there is a “shortage” of money depends on your beliefs on the pricing process and whether or not an increase in demand for money will lead to a general glut.

Semantic debate shouldn’t replace the real meat of the beliefs of monetary equilibrium theorists.

Ivan Georgiev August 11, 2011 at 7:24 pm

Mr. Catalan, you can download this file http://www.mediafire.com/?yf7s6crsdb8a5gz
where I have uploaded what is your text published on your ex-blog. the name of the posting was The Theory of Free Banking. Let me know whether this is what you lost and whether I can be of any help?

Jonathan M.F. Catalán August 11, 2011 at 7:33 pm

Yes, that’s what I was referring to. Thank you!

Malcolm the Sleaze August 11, 2011 at 7:37 pm

Too funny: JFC’s would-be patrons are getting their asses kicked here:

http://www.coordinationproblem.org/2011/08/and-now-on-youtube.html#comments

Rob R. August 25, 2011 at 12:09 pm

I see that you have a version of this paper on the Cobden site. I posted there but for some reason it never got moderated. Just in case you are still monitoring this blog, here is what I posted as I am interested in your answers.

Jonathan,

This is a very interesting article and I have a couple of questions.

- Supporters of FRB would accept that without FRBs to adjust the money supply following a change in its demand the process of price changes you describe would move things back towards equilibrium. However they would claim that with FRBs the process (since it avoids a change in the purchasing power of money) would be quicker and less disruptive to economic activity. I don’t really see anything in your article that identifies the negative consequences of the FRB theory here. Can you clarify what you see these as being and why a change in the PPM is preferable ?

- You say you support FRB, just don’t accept it has a role to play in maintaining monetary equilibrium. FRB theory however identifies this role (in expanding and contracting loans in response to changes in the demand for money) as key to their profit-maximizing strategy. Can you clarify how you would see FRB functioning without that part of their role taking effect ?

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