The Demand for Money Also Matters

      

In his most recent contribution to our discussion, Jeff Hummel misrepresents my particular “take” on the Mises-Hayek theory of the business cycle, so I’d like to take this opportunity to correct him, while also pointing out what I consider to be some serious errors in his own reasoning.

I’ve never intended, first of all, to revise the Mises-Hayek theory except by insisting that there are circumstances in which an increase in the nominal money stock, and especially in the stock of “fiduciary” media unbacked by high-powered money, instead of setting a Mises-Hayek type cycle in motion, merely serves to accommodate a like increase in the public’s willingness to add to the total extent of bank-intermediated saving.  Credit expansion serves in such cases not to drive lending rates below their “natural” levels, but to keep them from rising above those levels.   Expressed in the simple terms of the equation of exchange, the argument amounts to saying that, holding reserves constant, expansion of M is stabilizing rather than destabilizing so long as it serves to offset a like decline in V.  The claim is essentially the same as Hayek’s own theoretical stand that an ideal monetary policy is one that serves to stabilize the flow of spending, MV.

Given my desire to clarify this aspect of the theory, and also because I wished to show how a free-banking system tends to achieve the ideal in question, I naturally devoted a lot of attention to discussion of the implications of changes in money’s velocity.  But this theoretical emphasis doesn’t at all mean, as Professor Hummel claims, that I meant to grant “almost equal billing to velocity shocks along with monetary shocks as a source of business cycles.”  In fact I took no stand in the writings in question concerning the historical importance of velocity shocks relative to shocks, policy-based or otherwise, to the nominal supply of money.  To have taken such a stand would have meant delving much more deeply into the historical and statistical record than I ever intended to do in works mainly concerned with theory.

It follows that, although Hummel is perfectly correct in characterizing me as someone who “views negative velocity shocks as a potential source of depressions” (my emphasis), he errs both in claiming that there is something particularly “Keynesian” about my stand and in saying that it “differs from the orthodox Monetarist position, which denies the empirical significance of autonomous shifts in velocity” (emphasis in original).   To claim that something is “potentially” important is of course not to insist that it is, or has been, important in fact.

Later in his remarks, Hummel recognizes that a stable MV ideal conveniently avoids the problem of deciding which among many measures of the money stock to treat as a policy instrument or target.  But then he goes on to insist that it does so only by evading the crucial policy problem of “precisely” identifying “periods that represent artificial booms generating malinvestment.”  I confess that I don’t understand this argument at all and am indeed inclined to think it hopelessly muddled.  The entire point of the MV argument, mine and Hayek’s alike, is that the periods of excessive money creation are “precisely” those in which MV grows excessively rapidly (I shall come in a moment to clarifying “excessively”), for those are the times when money-stock growth exceeds concurrent growth in the demand for real money balances, thereby swelling the stream of payments.[11]   When productivity is stagnant, the swelling translates into rising prices of both factors and final goods, which serve to restore monetary equilibrium by causing a proportional increase in the demand for nominal money balances.  When productivity itself is improving, real money demand itself increases, so that final-goods prices needn’t rise as much, if indeed they must rise at all.

“In developed countries,” Hummel goes on to observe, MV “is almost always rising.” He then wonders, first, how it is possible in that case to tell whether it is rising so much as to cause an artificial boom.  The answer is that once people come to anticipate a pace of spending growth such as might otherwise have set a cycle in motion, the cyclical effects of the growth are muted or neutralized, and remain so until expectations are again exceeded.  That the real consequences arising from any particular rate of credit expansion will depend upon the extent to which the rate comes as a surprise has been conventional wisdom since the rational-expectations revolution.  It was, moreover, Mises own understanding long before then, as conveyed in his reply to Lachmann’s posing of more or less the same question Hummel now raises.[12]   That proponents of a stable MV ideal must recognize this truth hardly places them in a more awkward position than advocates of an M growth rate rule;[13] still less does it deprive them of an ability to offer meaningful policy recommendations by reducing their ideal to an “empty tautology.”  In Less Than Zero, for example, I offer perfectly concrete advice concerning the desirable target rate of MV growth, which elsewhere I have amended in light of high established growth-rate expectations only to the extent of allowing that the preferred target is best implemented gradually.[14]

Hummel next wonders how the stable-MV camp can possibly “determine if the cause [of a boom] is central-bank policy or something else.”  In fact, nothing could be easier, for if a central bank is running the show then it is responsible ipso facto for any undue expansion of spending.  If the proposed MV growth rate target is 3 percent and spending grows 5 percent, the central bank has erred by allowing M to grow by two percentage points too many.  (It matters not which M one refers to, so long as one has in mind the appropriate corresponding V.) 

Hummel, in contrast, appears to subscribe to the jejune view that central banks are responsible only for keeping growth of their own balance sheets within certain limits, without reference to what is happening either to the real demand for high-powered money or to the various determinants of the money multiplier.  His thinking commits him to claiming, for example, that in a fiat system a sharp increase in prices is to be regarded as the central bank’s fault if the rise is associated with proportional growth in the monetary base, but not if it follows a sharp decline in the public’s preferred currency ratio, or a sharp increase in money’s velocity — as if central banks weren’t also responsible for responding appropriately to such developments!   Since the Great Contraction of the early 1930s occurred despite the Fed’s having added to the stock of base money, perhaps Hummel is even willing to be so consistent as to insist that that debacle was caused not by “central-bank policy” but by “something else.” 

Although he might not be prepared to go so far as to absolve the Fed of blame for the Great Contraction, Hummel doesn’t flinch from denying that it played any part in fueling the recent housing boom and from portraying my and Larry’s “stubborn insistence” to the contrary as proof of our having worked our way into a theoretical corner.  But Larry and I (and plenty of other economists from a host of different schools of thought) are not pointing our fingers at the Fed simply because our theories prevent us from entertaining other possibilities.  We do so because the actual acceleration of spending growth, the record-low levels at which the real federal funds rate was kept, and other evidence besides warrants it. 

Hummel, on the other hand, is cocksure that the Fed did nothing wrong because “the growth rates of all the monetary measures ... were steadily declining” during the period in question.  But a central bank’s ultimate responsibility, as I have just said (and as I observed to Hummel and Henderson some time ago, without any apparent result[15] ), is not that of seeing to it that this or that monetary measure grows at such-and-such a rate; its ultimate duty is that of seeing to it that the supply of money grows only as much as is needed to accommodate prior growth in the real demand for money balances.  It follows that, when the demand for real balances declines, a responsible central bank must allow the nominal money stock to decline no less rapidly, or else risk contributing to a monetary excess with all that that implies.  The monetary statistics Hummel refers to show only that the nominal stock of money was declining, but not that it was declining as rapidly as it ought to have.  That MV was in the meantime growing exceptionally rapidly proves, on the contrary, that the money stock wasn’t declining rapidly enough.

[11] At one point Hummel observes, bafflingly, that “Surely credit expansions that are inconsistent with underlying time preferences are not the sole cause of changes in velocity.” How he can read into any defense of stable MV an implicit assumption  that changes in V must occur only in response to excessive credit expansion is utterly beyond me.   

[12] Ludwig von Mises, “‘Elastic Expectations’ and the Austrian Theory of the Trade Cycle,” Economica 10 (August 1943); Ludwig Lachmann, “The Role of Expectations in Economics as a Social Science.”  Economica 14 (February 1943). 

[13] Or does Professor Hummel mean to suggest that the cyclical consequences of, say, a 10 percent annual growth rate of M2 will be the same if the public anticipates a 10 percent growth rate as they would be if it anticipated no growth at all?

[14] George Selgin, Less Than Zero: The Case for a Falling Price Level in a Growing Economy (London: Institute of Economic Affairs, 1997).

[15] “Guilty as Charged,”  Mises Daily (November 7, 2008), in reply to David R. Henderson and Jeffrey Rogers Hummel, “Greenspan’s Monetary Policy in Retrospect,” Cato Briefing Paper 109, November 3, 2008. Online at: https://mises.org/daily/3200