8. Macroeconomics and Coordination

CHAPTER 8

Macroeconomics and Coordination^*

A more exact, though wordy, title for this chapter would be “Macroeconomics, Coordination, and Discoordination.” Macroeconomics studies disruptions to the economywide coordination processes that microeconomics explains. An emphasis, instead, on aggregate demand facing aggregate supply is hopelessly superficial.

DISARRAY AND OPPORTUNITY

It is standard nowadays to bewail disarray in macroeconomics and monetary theory. Fundamentalist Keynesianism, as we might call it, dominated textbooks and policy circles for roughly three decades. Experience and theory then discredited it. The fundamentalists brooded about inadequacy of total spending (or occasionally the reverse), about the propensity to consume out of real income, and about a saving gap that grows with income and wealth and so becomes all the harder to fill with investment spending, especially as real capital formation leaves fewer attractive opportunities for still further private investment. Even nowadays, policymakers and a few economists still cling to some such doctrine by default and still recommend expanding “aggregate demand” to “stimulate” national and world economies, albeit at the risk of price inflation implied by the equally discredited notion of the Phillips curve.

An alternative school of Keynesian interpretation stems from Robert Clower (1984) and Axel Leijonhufvud (1968,1981). As history of economic thought it maybe questionable, but its substance deserves ample attention. It features such concepts as absence of the (supposed) Walrasian auctioneer, incomplete and costly and imperfect information, false price signals, sluggish price adjustments, quantity changes as well as price adjustments, the duality of people’s decisions about particular transactions according as they are or are not frustrated in accomplishing other desired transactions, and the “income-constrained process” of infectious recession and recovery.

A quite different group of self-styled Keynesians centered at Cambridge University expresses sweeping skepticism about market-oriented economic theory. In the United States, economists associated with the Journal of Post Keynesian Economics form still another school.

Some “monetarists” or “monetary-disequilibrium theorists” continue active in the tradition of David Hume, Henry Thornton, Clark Warburton, Milton Friedman, Anna Schwartz, Karl Brunner, and Allan Meltzer. Their influence has been eroded, however, by developments that have made their formerly suggested policy of steady monetary growth no longer applicable and also by misinterpretations of experience. Monetarism has also suffered from attention paid to two schools that have distorted and exaggerated certain of its tenets. The New Classical economists (including Robert Lucas, Thomas Sargent, and Robert Barro) proclaimed rational expectations and equilibrium always. (In effect, everything is always coordinated, or almost so.) Their position gained attention more because of its coherence with theoretical and methodological fashion than because of its empirical substance, later widely questioned (Howitt 1990, chap. 4).

The real-business-cycle school carried the exaggerations of New Classical economics still further. It interpreted macroeconomic fluctuations as efficient responses to underlying real changes (as in technology) rather than as consequences of monetary disturbances. Robert King, Charles Plosser, and Edward Prescott have written along this line; Strongin (1988) and Stockman (1988) provide convenient surveys. Gary Hansen and Randall Wright (1992) provide an example of tinkering with this theory to rescue it from recalcitrant facts; they would do well to remember about Ptolemy and epicycles. Gary Hansen and Edward Prescott conveyed the impression, without explicitly saying so, that they were answering “yes” to the question posed by the title of their 1993 article, “Did Technology Shocks Cause the 1990—1991 Recession?”

Both the New Classical and real-business-cycle schools tacitly attributed near-perfection to markets (including “efficient markets” in securities), as if their members were congratulating themselves on being “more free-market-oriented than thou.” (I am reporting my impression of doctrines, not conjecturing about anyone’s motives nor saying that exaggeration crowds out scholarly substance; still, fads do come and go in the academic world.)

Self-parodying free-marketry has handed an opportunity to look sensible by contrast to self-styled New Keynesians, who share several perceptions of reality with the monetarists and who take imperfect competition and price and wage stickiness seriously. (Examples of the work of this misleadingly named school appear in Mankiw and Romer 1991.) As Axel Leijonhufvud (1986) has noted in a more general context, macroeconomists have been playing musical chairs with doctrinal positions and labels.

Nowadays (around 2010), a new-classical/new-Keynesian synthesis, also called dynamic (or dynamic stochastic) general-equilibrium theory, enjoys academic prestige. It explores the properties of mathematical models and tweaks them to remove blatant contrasts with statistics of the real world. It assumes rational expectations, which is sensible enough if taken to mean no more than that people will not persist in making recognized mistakes. It assumes that markets are always in or near equilibrium—in some stretched sense of that word—so showing scant attention to the issues of coordination and discoordination that concern Austrian economists.¹

This disarray in macroeconomics gives Austrian-school economists, as well as monetarists and New Keynesians, an opportunity to set the main stream of macroeconomics on a sounder course. Two major characteristics, besides others mentioned below, especially equip Austrians to seize this opportunity. First, it focuses on the central problem bridging micro and macro economics, the problem of economywide coordination. (Gerald O’Driscoll aptly entitled his doctoral dissertation Economics as a Coordination Problem.) Second, it is readier than other free-market-oriented schools to face reality as it is, “warts and all.”

COORDINATION

Robert Clower (1984, p. 272) observed that

the approaches of the Keynesians, monetarists, and new classical economists to monetary theory and macroeconomics will get us exactly nowhere because each is founded, one way or another, on the conventional but empirically fallacious assumption that the coordination of economic activities is costless.

As this remark suggests, the key question of money/macro theory is not “What determines whether aggregate demand for goods and services is deficient or excessive or just right?” but “What determines whether the processes of exchange and coordination in an economy of decentralized decisionmaking are working smoothly?”

Austrian economists recognize the disaggregated character of economic activity. They take seriously the profound differences between an advanced economy of fine-grained division of labor and the nearly self-sufficient miniature economy of a medieval monastery or manor or of Swiss family Robinson on its desert island (cf. Eucken 1950). Knowledge of wants, resources, technology, and market opportunities, including knowledge of temporary and local conditions, is radically decentralized and simply could not be made available to central planners in anything approaching its fullness. If knowledge is not to go to waste, production and consumption decisions must be radically decentralized (Hayek 1945/1949). Specialization greatly enhances productivity. People produce their own particular goods and services to exchange them away, thereby exercising demand for what other specialists are producing. But what coordinates all these fragmented activities?

The debates over economic calculation under socialism and capitalism initiated by Ludwig von Mises and Friedrich Hayek illuminate the scope of this question (cf. the literature reviewed in Yeager 1994). Even the mere physical meshing of activities as portrayed in a self-consistent input-output table is hard enough to achieve in the absence of genuine markets and prices, as Soviet experience testifies. Full coordination is a still more demanding task. It requires taking account of physical and subjective substitutabilities and complementarities among goods and services and factors of production in their various uses in consumption and production so that no unit of a productive resource goes to satisfy a less intense effective final demand to the denial of a more intense demand. Market bids and offers for resources and final goods play a central role in this process, but its very complexity permits glitches.

Forces of unbalanced supply and demand tend, to be sure, to press disequilibrium prices toward their market-clearing levels. What ensures, however, that these coordinating forces operate rapidly enough and that impediments to transactions do not reinforce each other in the meanwhile to a degree that shows up as recession or depression? Because the fundamental insight of Say’s Law is correct—supplies of particular goods and services constitute demands for others, sooner or later—the fundamental macroeconomic problem cannot be a deficiency of aggregate demand. However, anything that impairs the processes of market exchange also impairs production. People work and produce in the expectation of being able to exchange their outputs away, and they will not persist indefinitely (especially not in buying inputs for unsalable outputs) if their attempted exchanges keep on being frustrated. Goods and services exchange for each other not directly but through the intermediaries of money and of credit denominated in and ultimately to be settled in money. Monetary disorder can snarl up the process of exchange and so impede production. Austrians, like monetarists, are prepared to take this snarl seriously.

These considerations help argue, incidentally, for putting the micro semester of a Principles of Economics course before the macro semester. Students can hardly understand disruptions of coordination until they know that a coordination problem exists in the first place and understand how the market process solves it when it is working well.

Coordination requires more than correct prices. In Walrasian models of general equilibrium, the “auctioneer” not only achieves the whole array of market-clearing prices but also puts trading partners in contact with one another, obviating the costly mutual searches otherwise necessary. In effect he makes all assets equally liquid—equally readily marketable or usable as means of payment—at their general-equilibrium prices. It is questionable whether models featuring such a mythical personage can contribute much to illuminating macroeconomic issues.²

In the real world, however, a worker may be unemployed not necessarily because he insists on too high a wage rate but because he and a suitable employer have not yet made contact. Various startup costs of a new employer-employee relation also enter into the story. In the real world, prices are not the only bearers of signals and incentives about potential transactions. Quantities also perform these functions—quantities of goods, services, and factors in accomplished transactions, frustrated transactions, and inventory buildups and rundowns. Inventory management, quality verification, advertising, and informational and other such activities bear on whether transactions can go forward to the mutual benefit of the parties. These activities have “transactions costs” in an inclusive sense of the term. Many of them impede not only actual transactions but even messages of willingness to buy or sell.

Recoordination to recover from recession requires more, then, than just adjusting prices and wages. Business contacts must be restored or revised. Information, including information about market conditions, must be brought up to date and transmitted.

OBSTACLES TO COORDINATION

Costs and complexities of reality help explain the value of habits, routines, and long-term business relations, as between supplier and customer, employer and worker, and borrower and bank. Not every business relation is continuously open to price revision, as abstract equilibrium theory might seem to recommend. The very concept of different degrees of liquidity of various financial and real assets reflects recognition that price is not the only determinant of whether potential transactions get consummated. If all goods were perfectly liquid, as tacitly assumed in the Walrasian model, then impediments to communication would have been removed. Howitt (1990), writing partly under the inspiration of Clower and Leijonhufvud, surveys some of foregoing themes, as does Okun (1981). Howitt, as well as Hall (1991), comments on difficulties of finding trading partners in “thin” as opposed to “thick” markets. By analogy, my installing a telephone benefits people who might want to reach me but imposes a congestion cost on people who might want to reach people talking with me.

Whether a particular transaction can go forward depends on much more than the terms subject to negotiation between the two potential trading partners. Whether a manufacturer and a potential employee could both benefit from their relation depends on more than the wage rate. It depends on prices charged by competitors and by suppliers of materials, on terms on which energy, transportation, and credit are available, on market conditions facing potential customers, on inventories of various kinds, and on much else besides.

Changes affecting such conditions are continually going on, challenging entrepreneurs to cope with them, as by developing new business opportunities to replace fading ones. In ordinary times, entrepreneurs continually accomplish myriads of interdependent microeconomic adjustments without palpable macroeconomic disorder.

When major economywide disruptions occur, however, it is not surprising that the many necessary interlocking adjustments should stretch out painfully over time. Much besides prices and wages must change, for even a purely monetary shock (whatever one might be) has “real” consequences. Knowledge must be transmitted and received, risk allowed for, combinations of factors and products in production and consumption revised, search conducted, trading partners contacted, and new quantities of goods produced and exchanged. Stickiness of prices and wages delays the transmission of appropriate signals and incentives. (“Price stickiness” may serve as a convenient term alluding to myriad obstacles to prompt and painless adjustment. It is a shorthand label for a wide range of circumstances.)

By adopting the fashionable assumption of rational expectations, New Classicals and subsequently even the New Keynesians tacitly assumed away central aspects of the economywide coordination problem. They replaced a vision of people trying to set prices and quantities and strike bargains in a world of fragmentary and dispersed information with an unrealistic vision of remarkably well-informed people—informed, to be sure, not of specific future quantities and prices but well informed on average about probability distributions. To assume rational expectations oversimplifies problems of coordinating people’s beliefs: “No one makes systematic errors in guessing the values of variables that depend in turn upon others’ guesses” (Howitt 1990, pp. 12-13).

“IMPERFECTIONS” OF REALITY

In using their word, I am defying theorists who judge reality “imperfect” in comparison with textbook chapters on equilibrium under pure and perfect competition and who thereby damn reality for being real. Of course no “Walrasian” auctioneer is at work achieving ideal outcomes. Of course not all imaginable intertemporal markets and contingent-state markets exist. Of course full coordination is never achieved; and it is approached, to the extent that it is, through the piecemeal, asynchronous gropings of myriads of entrepreneurs. Theory relevant to the real world cannot confine itself to equilibrium analysis and comparative statics. Instead of a state of affairs, competition is a process. Except perhaps for organized exchanges for standardized commodities and securities, no impersonal “market” adjusts prices to changed conditions. People change prices, and only after they have perceived reasons to do so. Reasons include opportunities offered by changes in technology and notably include perceived market imbalances and frustrations of transactions at the old prices. Perceptions and responses are not instantaneous.

Already in his Theory of Money and Credit (1912/1981, pp. 186—187), Ludwig von Mises recognized such facts of reality. Many prices are deliberately set, obviously in retail trade, and set by trial and error.

Now this phenomenon is not accidental. It is an inevitable phenomenon of the unorganized market. In the unorganized market, the seller does not come into contact with all of the buyers, but only with single individuals or groups... .Consequently the seller fixes a price that in his opinion corresponds approximately to what the price ought to be (in which it is understandable that he is more likely to aim too high than too low), and waits to see what the buyers will do... .The sole way by which sellers can arrive at reliable knowledge about the valuations of consumers is the way of trial and error.

Institutional forces work to postpone price changes otherwise called for by small or transitory changes in supply and demand (1912/1981, p. 134). “Every change in the market data has its definite effects upon the market. It takes a definite length of time before all these effects are consummated, i.e., before the market is completely adjusted to the new state of affairs” (Mises 1949/1963, p. 652).

[C]hanges in the factors which determine the formation of prices do not produce all their effects at once. A span of time must elapse before all their effects are exhausted. Between the appearance of a new datum and the perfect adjustment of the market to it some time must pass... .In dealing with the effects of any change in the factors operating on the market, we must never forget that we are dealing with events taking place in succession, with a series of effects succeeding one another. We are not in a position to know in advance how much time will have to elapse, (p. 246)

Mises recognizes a certain inertia of prices (1912/1981, pp. 133—136). Relatedly, he recognizes that flexible exchange rates tend to move ahead of their purchasing-power parities; relatively, prices of many goods and services are sluggish (1949/1963, pp. 455—456). Mitchell (1908/1966, pp. 259—283) observed the same phenomenon in detail in the U.S. “greenback” period of 1862—1878. Mises also observes more of a historical element in the value of money than in the value of any ordinary good.

[A] historically continuous component is contained in the objective exchange value of money. The past value of money is taken over by the present and transformed by it... .Prices change slowly because the subjective valuations of human beings change slowly... .If rapid and erratic valuations in prices were usually encountered in the market, the conception of objective exchange value would not have attained the significance that it is actually accorded both by consumer and producer.

In this sense, reference to an inertia of prices is unobjectionable. (1912/1981, P.133)

It is so far as the money prices of goods are determined by monetary factors, that a historically continuous component is included in them, without which their actual level could not be explained, (p. 135)

MONEY AND PRICE STICKINESS

Without explicitly saying so, then, Mises clearly implies that money’s role as unit of account contributes to the stickiness of prices. People are in the habit of formulating their subjective valuations of goods in terms of the money unit, and subjective valuations ordinarily do not change suddenly. Even if relatively objective developments do call for a change in the market value of any ordinary good or of the money unit itself, people require time to perceive and react to these changes and to reformulate their valuations of goods in money (1912/1981, pp. 133-135; 1949/1963, p. 426).³

One might add, as Lerner (1952, pp. 191-193) did, that the most sweeping source of price stickiness lies in the very nature of money. In a money economy, unlike a barter economy, people need not bother about all the real (relative) prices that might concern them, for a thing’s money price indicates the value of other things that one might have instead. A price conveys information and guides decisions, however, only if it is reasonably dependable. Imagine how difficult decisions and coordination would be if a thing’s price today were only a poor clue to its price tomorrow. Substantial money and price inflation or deflation distorts relative prices and decisions and impairs coordination because not all money prices can be equally flexible. On the other hand, stability in the purchasing power of money tends to reinforce itself and deter accidental or random fluctuations; being the general measure of value supports institutions, habits, and expectations that work to this effect. In short, thoroughgoing wage and price flexibility would keep money from serving its normal purposes; it could not survive. A degree of price stickiness—or dependability—is no mystery.⁴

A leading theme of Mises’s theory is that money is far from neutral in its effects on quantities, incomes, and relative prices (1949/1963, pp. 408ff). Prices do not automatically set themselves in proportion to the total quantity of money, as a naive interpretation of the quantity-theory equation might suggest. Some changes occur relatively rapidly, others after long delays. People’s responses to ongoing monetary and price inflation change as experience accumulates and expectations change accordingly. Mises’s discussion of differential price changes constitutes emphatic recognition of the stickiness of many prices. This recognition is not a distinctively Keynesian notion, despite remarks by textbook authors neglectful of the history of economic thought.

Mises accepts the concept of general equilibrium—the evenly rotating economy, as he calls it—as a tool of analysis. Using it in no way entails supposing that the

final prices corresponding to this imaginary conception are ... identical with the market prices. The activities of the entrepreneurs or of any other actors on the economic scene are not guided by consideration of any such things as equilibrium prices and the evenly rotating economy. (1949/1963, p. 329)

Austrians are concerned with process—not merely with functional relations in the mathematical sense but with who does what, why, when, and how. Attention to process bars exclusive infatuation with the equilibrium state. (Austrian scorn for the neo-Walrasian brand of general-equilibrium theory is well known. It might well be better focused, however, than it habitually is.) Austrian economics recognizes the scope for entrepreneurship in disequilibrium. Recognizing disequilibrium is one aspect of Austrian realism. Austrians are willing to see the world as it actually is. They are not sidetracked into supposedly “rigorous” theorizing about imaginary worlds that diverge from reality in crucial respects. Austrians recognize that pure and perfect competition, like equilibrium, are abstractions and not reality. These imaginary extreme conditions do have roles to play in theorizing, but economists should recognize when they are inapplicable. In understanding money/macro phenomena and in building bridges between macro and micro economics, it is essential to recognize that sellers are in general not pure price takers and that they are not already selling all of their product or of their labor that they want to sell at the prevailing price. In macroeconomics it is important to recognize that most prices are set and not impersonally determined by the interplay of atomistic supply and demand.

The Austrians’ concern for facts of reality is often overlooked because of their supposed insistence on a purely a priori method. This term, notably as used by Ludwig von Mises, unfortunately invites misinterpretation. So used, a priori suggests an unintended sharp contrast with empirical. Mises did not mean that all important propositions of economic theory can be spun out of factually empty logical truisms. He relied, rather, on axioms for which factual evidence constantly presses itself on us so abundantly that we can hardly imagine a world to which those axioms did not apply (cf. Rothbard 1957). Austrians do not—or should not—confine the honorific term “empirical” to propositions dug out by arduous labor and of doubtful general validity after all.

In related respects, Austrians are more realistic than self-congratulating “empirical” researchers. They open their eyes to what sorts of method have and what sorts have not brought important results. They look at the facts bearing on whether or not stable functions exist that quantitatively and dependably describe relations among economic magnitudes and that might be relied on for forecasting. They are at least as ready as other economists to accept the facts that call into question overambitious, activist, fine-tuning policies whose success presupposes knowing durable quantitative relations.

BOOMS, SLUMPS, AND CONTAGION

What explains the recessions that interrupt prosperity from time to time?⁵ Each recession is a specific historical event. Researchers have the job of investigating each one, asking whether many of them share some dominant feature and discarding hypotheses that do not fit the facts. It is premature to start by supposing that one theory fits all, just as it would be to expect a single cause of wars or revolutions or electoral landslides. Macroeconomics is inherently a messier field than micro. Micro describes straightforward principles that bear on decisionmaking, coordination, and possible specific distortions of resource allocation. Macro studies what might go wrong on a large scale. Micro bears an analogy with describing the structure and functioning of a healthy human body; macro resembles the study of what might go wrong—diseases and wounds of innumerable kinds.

Narrative and statistical history has convinced monetarists that most recessions exhibit a monetary disturbance—a shrinkage of the quantity of money or, anyway, its downward deviation from a trend that would accommodate real economic growth without a general fall in prices and wages. Monetarists can cite ample historical and statistical evidence from many times and places. It is unnecessary to review this evidence here, but undue neglect warrants a plug in the list of References for an insightful and prescient article in the monetarist tradition written by Harry Gunnison Brown just a few days before Franklin Roosevelt took office at the depths of the Great Depression in 1933. In articles of 1989 and 1990, Christina and David Romer review recessions evidently caused by monetary policy in the United States since World War II.

Money is not the only thing, however, conceivably disrupting coordination. Severe “real” disturbances might overwhelm entrepreneurial efforts to cope with them. It is instructive to ponder what would happen to total output if the country’s telephone system (Hall 1991, p. 23) or, more starkly, if all of its electronic communications and data processing were somehow to fail for several months.

In historical fact, however, it is implausible to put special blame on such “real” disturbances for the major recessions and depressions actually experienced. Instead of being readily attributable to changes in productive capacity, recessions and depressions exhibit what look like pervasive deficiencies of demand, pervasive difficulties in finding customers and finding jobs. A “real” theory assuming continuous market equilibrium is especially hard put to explain eventual macroeconomic recoveries.

Even a real disturbance as great as the shift from war to peace in 1945-1946 brought a surprisingly modest macroeconomic ripple, with low unemployment despite demobilization. The two oil-price shocks of the 1970s might count as real causes of recession, but even these had monetary aspects. They not only made old patterns of quantities and relative prices wrong but also shrank real cash balances and reshuffled their ownership. Furthermore, previous money and price inflation had helped trigger the oil shocks themselves (and this inflation in turn arguably traced to a built-in bias of the Bretton Woods system).

Ludwig von Mises aptly entitles one of his chapter sections “The Fallacies of the Nonmonetary Explanations of the Trade Cycle” (1949/1963, pp. 580-586; cf pp. 554-555). He particularly criticizes “the two most popular varieties of these disproportionality doctrines”: the durable-goods (or echo-effect) doctrine and the acceleration principle. He judges them hard to square with the general, economywide character of business expansions and contractions (pp. 583, 585).

The crisis and recession beginning in 2007 had a conspicuous real element—the collapse of a housing boom. In its background, however, lurked a monetary policy of arguably excessive liquidity and too-low interest rates, as well as ill-considered government housing and mortgage policies and private financial imprudence.

This recession illustrates the contagion of distress through several channels. Insolvency or illiquidity of some institutions weakens others holding claims on them. Consider an example. Consumers buy houses, putting up only a very small fraction of the purchase prices in money of their own and obtaining mortgage loans for the rest. Now a financier “packages” these mortgages into bonds. More specifically, he buys these mortgage claims from the original lenders (unless he already owns them by himself being the original lender). He gets the necessary funds only fractionally from resources of his own and issues bonds for the difference. His bonds are in turn bought by further financiers, who also pay only a fraction of the purchase price in cash and obtain the rest by issuing still further bonds. Bonds bought serve as collateral for the loans obtained (that is, further bonds issued) to pay for the bond purchases. And so on. In short, loans are made with borrowed money obtained in turn mostly by borrowing: bond sales finance bond purchases. At the end of the chain are the saver-investors who pay in full, for example, individuals who invest in bonds or bond mutual funds or participate in pension funds.

At some stage in the chain, a financier may issue bonds divided into two or more tranches, some appearing safer by having a primary claim on earnings and ultimate repayment and lower tranches being riskier by having only subordinate claims. Upper-tranche ultra-safe bonds are apparently manufactured, then, out of low-quality mortgage loans.

Investing largely with borrowed money is “leverage.” “Deleveraging” shook a multitiered structure of claims based on claims. The marketability of securities declined as their actual values became unknown.

Credit-default swaps are in effect insurance policies issued to cover the risk of default on bonds and so make the bonds more marketable. Ordinarily the insurance providers need not expect having to make good on any substantial fraction of their policies at once, so they hold liquid funds amounting to only a small fraction of their total potential liabilities. “Ordinarily,” for in times of crisis the credit-default swaps enter into the crumbling of the leveraged chain.

The chain is more fragile than one might suppose on the grounds that, indirectly and ultimately, houses largely back the bonds held by the investors at the end of the chain. The netting-out of intermediate stages is not reassuring, for financial distress might strike any of the several institutions in the chain and break it.

Even so, compounded leverage is not inherently fraudulent; for it can provide the benefits of sophisticated financial intermediation. It productively allocates the burdens of saving and risk-bearing to the parties most able and willing to bear them in view of prospective returns. Complexity breeds ignorance, however; and unscrupulous operators may exploit it.

Contagion marks booms and slumps. In times of exuberance, things usable as collateral rise in price, permitting bigger loans. Furthermore, lenders grant larger loans relative to collateral. This expanded credit bids up asset prices further. And so on upwards until the spiral goes into reverse. Lenders become more demanding. The troubles of operators holding depreciating assets infect their creditors. The multitiered leverage aggravates the downward spiral (Geanakoplos 2010).

Mortgage foreclosures characterize just one channel of contagion. Houses stand empty, lawns go untrimmed, the neighborhood depreciates, house prices fall further and trigger further defaults, and holders of mortgage-backed bonds suffer.

Structural contagion through these channels, as one might call it, is joined by expectational and psychological effects. The stock market is just one of the things registering and perhaps intensifying optimism or pessimism. Investment fads and herd behavior are evident as people take clues from one another. After a bubble collapses, fear engenders more fear. Geanakoplos (2010) writes repeatedly of “scary bad news,” by which he means news that is not merely bad but that intensifies itself by worsening general uncertainty. Gorton (2008) emphasizes information and its absence, as about the degree and location of risk. Financial complexity erodes information.

During the recession that began in 2007, lenders held back from lending; banks accumulated huge excess reserves of base money newly created by the Federal Reserve; and investors and consumers postponed spending. The demand to hold money and near-money assets strengthened relative to income and expenditure: the velocity of money fell. Uncertainty was at work according to interpretations circulating widely toward the end of 2010. Businesses could hardly predict the impact of the mammoth new laws affecting health care and finance. Uncertainty about whether the Bush-era tax cuts would be allowed to expire, extended, or modified contributed to hesitation in hiring and in making major expenditures.

MONETARY DISORDER

To understand what scope disordered money has for doing damage, it helps to recall money’s immensely valuable services when it works even halfway properly. It vastly facilitates the exchange of goods and services for one another. Indirect exchange through money takes place not only among people working in different sectors of the economy but also over time. Through building up and drawing down cash balances and through credit transactions, people can arrange to receive what other people produce either before or after they deliver their own outputs. This intertemporal aspect of money facilitates the pooling and mobilization of savings and so promotes real capital formation, which, like specialization, enhances productivity.

Money serves not only as the medium of exchange but also as the unit of account, the unit in which prices are quoted, bookkeeping accomplished, contracts written, debts expressed, subjective evaluations formulated, benefits and costs of activities appraised, prospective and past profits and losses estimated and recorded, and taxes levied. The vital roles of market prices, profits, and losses expressed in money received attention in the debates over socialist economic calculation initiated by Ludwig von Mises. When monetary disturbances require substantial changes in general levels of prices and wages, then, whether or not these changes occur promptly, the functions of prices, profits, and losses in conveying signals and incentives suffer disruption. One notable glitch is the debt-deflation aspect of depression described by Irving Fisher (1933). Comparable effects occur when price inflation or deflation turns out substantially greater or slighter than people had allowed for in their borrowing and lending and other plans. Previously scheduled debt and interest payments can become disruptively burdensome when debtors and so their creditors suffer disappointments of kinds other than or in addition to price-level or price-trend changes.

Money is potentially a “loose joint,” as F.A. Hayek said (Garrison 1984, 2001), between decisions to produce and sell things on the one hand and decisions to buy on the other hand. In accomplishing exchanges, people (and business firms) routinely receive payments into and make payments from holdings of money, a fact whose significance Mises well understood in developing his cash-balance approach to monetary theory (1912/1981). The sizes of cash balances desired are related to the sizes of people’s and firms’ expected inward and outward flows of payments (among other variables). If desired amounts of money exceed or fall short of actual amounts, then people try to adjust their holdings by modifying their behavior on the markets for goods and services and securities. As Mises wrote,

A shortage of money means a difficulty in disposing of commodities for money... .Under the present organization of the market, which leaves a deep gulf between the marketability of money on the one hand and the marketability of other economic goods on the other hand, nothing but money enters into consideration at all as a medium of exchange. (1912/1981, p. 157)

Theories of difficulty in making contact with potential trading partners help illuminate the decline of the velocity of money in recessions (see the cited works of Clower, Leijonhufvud, and Hall, and particularly Clower 1990, p. 82). With many desired sales thwarted, people find themselves, more or less by default, holding more money than usual relative to their incomes and expenditures. The grim business scene, together with uncertainty and precaution, counts against acting to get rid quickly of cash balances that would otherwise seem excessive.

In some ways, as just implied, imbalance between money’s supply and demand is self-aggravating. More generally, supply and demand stay in equilibrium less readily for money than for ordinary goods and services. Because money is the one thing routinely traded on all markets, its supply and demand do not confront each other on a market of its own and cannot be equilibrated with each other through a price adjustment of its own. Equilibrating processes do operate, but only indirectly, over time, and in a piecemeal manner through trials and errors in adjusting quantities and prices on innumerable specific markets. When an excess demand for money requires widespread cuts in prices and wages, sellers and wage negotiators in many or most of the markets for individual goods and services have reason to delay cuts of their own while waiting for a clearer reading on market conditions and waiting to see what other sellers—competitors, workers, suppliers—will do.

Rapid coping with monetary disequilibrium is difficult because knowledge is scattered in millions of separate minds—knowledge about tastes, resources, production possibilities, exchange opportunities, money and credit conditions, and conditions on specific markets. Because the market is, among other things, a mechanism for conveying signals and incentives, it would be inconsistent both to recognize these functions yet to suppose (as the rational-expectations theorists nearly do) that transactors somehow already have the knowledge that the price system works to convey. The market process has no quick and easy substitute.

Mises repeatedly emphasized the delayed and nonuniform responses to money-supply changes (1912/1981, pp. 162-163, where he cites observations of David Hume and John Stuart Mill; Mises 1990, chaps. 4-6). “The essence of monetary theory is the cognition that cash-induced changes in the money relation affect the various prices, wage rates, and interest rates neither at the same time nor to the same extent” (1949/1963, p. 555). Although Mises focuses his critical attention on money and credit expansion and its consequences, he recognizes the damage done to business when a credit expansion ceases (p. 568). “Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities” (p. 567). Mises alludes (p. 568) to the damage done by deflation and credit restriction required by Britain’s return to the prewar gold parity of its currency after both the Napoleonic wars and World War I.

CREDIT AND MONEY

Credit disruption accompanies or even seems to overshadow monetary disruption in some episodes. Again the current recession provides an example. When the housing boom fed by cheap credit went into reverse, spreading fear made banks and other lenders, including those in the commercial-paper market, hesitant to lend. Some businesses, deprived of credit, had to curtail their operations, spreading distress to their suppliers and laid-off employees. Others that might still have obtained credit did not seek it for lack of attractive opportunities to employ the money.

Credit contraction may indeed count as a “real,” nonmonetary, factor in recession; but it still had monetary aspects. Velocity, as already mentioned, fell, and for any plausible concept and measure of money used in the calculation. Income saved from consumption but not devoted to real investment or to nonmonetary assets was allocated to the one remaining asset, namely money, narrowly or broadly defined. If there were no such asset to latch onto, credit contraction could not have occurred, or not in any familiar way (Cover and Hooks 1989). MV=PQ, the familiar tautological equation of exchange, remains a useful check on what implies what.

THE TIME ELEMENT

Perhaps more so than other schools, Austrian economists emphasize one banal fact: economic plans and activities stretch out over time. (Dynamic general-equilibrium theory does formally take account of time in its models, but not in the way Austrians do.) This is one more reason why price flexibility cannot keep markets continuously cleared. People cannot do everything at once; they cannot set all prices at the same time and revise all of them equally often. Long-term contracts fix some prices; principal and interest on debt are in the nature of preset prices. A change in the general level of prices necessarily disrupts previous price relations.

A more general point is that coordination requires intertemporal as well as interindustry meshing of plans and activities. Roger Garrison (1984, 2001) identifies the intersection of the “market for time” and the “market for money” as the subject matter of macroeconomics. Money is not the only Hayekian “loose joint” in a market system. A merely loose relation also holds between a definite assortment of capital goods and the subsequent demand for the corresponding consumer goods. This looseness permits maladies such as “overinvestment” or “underinvestment” or “malinvestment.” Once committed to a certain course, people cannot “instantaneously and costlessly change that commitment; thus the passage of time and its irreversibility are matters of paramount importance in understanding economic activity” (Laidler 1975, p. 5).

A further link between the universals of time and money (so called by Garrison 1984, 2001) is that people hold money to cope with Keynes’s “dark forces of time and ignorance.” To the extent that they want to postpone consumption while keeping their options open about the timing and specific types and amounts of their future consumption and investment, people hold financial claims, including money. Keeping options open is possible for individuals but is not possible for the economy as a whole (or is possible only to a lesser extent, through construction of versatile rather than highly specialized capital goods). Private attempts to do the socially impossible—keeping options open—epitomize the intertemporal “loose joint.”

SAVING, INVESTMENT, AND MONEY

Fundamentalist Keynesianism worried about the separation of saving and investment decisions. Since both types of decision concern the future, an imbalance between desired saving and desired investment implies intertemporal discoordination. The interest rate (or array of rates) alone cannot ensure saving/investment equilibrium, for interest is not the price of those two aggregate flow magnitudes. Instead, it is the price of loans, broadly interpreted, or, more comprehensively, the price of “waiting” performed through ownership of claims and other assets.

Imbalance implies monetary disequilibrium; yet the interest rate is not the equilibrator of money’s supply and demand, either. To understand the relation between saving, investment, and money, let us focus on the case of oversaving, seen as pervasive deficiency of demand for currently produced or producible goods and services. As follows from the two-sided character of markets and of both actually accomplished and unsuccessfully attempted transactions and as Walras’s Law states, supply-and-demand imbalance for some things implies imbalance in the opposite direction for other things. (The aggregate value of all excess demand quantities, due account taken of algebraic sign, is tautologically equal to zero.) In the case considered, excess supply (negative excess demand) for currently produced goods and services implies (positive) excess demand for other things. What might this other thing or things be?

People who are trying to save (instead of fully spending their current incomes on consumption) are by that very token trying to acquire savings (“savings” with the s) in the form of real or financial assets. Which assets? If the savers themselves are buying labor and other resources to construct new capital goods, they are not contributing to any deficiency of current total spending. (Hindsight might later reveal the particular mix of capital goods constructed to be inappropriate, but that is a problem different from oversaving.) If, instead, savers are acquiring new stocks or bonds from issuers who use the monetary proceeds (the command over resources released from supplying current consumption) to construct capital goods, again no oversaving occurs. If savers are buying already existing physical assets or securities, the question shifts to what their sellers are trying to do with the proceeds. If those asset sellers are using the proceeds for consumption or new capital construction, again no oversaving occurs. If they are trying to shift wealth into other vehicles of saving, the question reappears of what these other vehicles might be: what is the thing or things whose excess demand matches the deficiency of demand for currently produced goods and services?

How, furthermore, could the excess demand for this something persist? Consider how an excess demand might work itself out. (1) The thing’s quantity might increase, as with automobiles and certain claims on financial-intermediary institutions. (2) Its price might rise or its yield fall, as with Old Masters, securities, and claims on financial intermediaries. (3) If its quantity and price are both rigid, frustrated demand for the thing might divert itself onto other things, with macroeconomic consequences much the same as if the diverted demand had run in favor of the substitute goods in the first place. (4) For only one thing does none of these responses to excess demand operate, requiring some quite different process. That thing is money, the medium of exchange. (Even nearmoneys can respond in quantity or price or yield.)

In the current U.S. monetary system, the quantity of money depends on the policy-determined stock of government base money and the circumstances represented in the textbook money-multiplier formula. Of the four supply-and-demand-equilibrating mechanisms, the first, the quantity response, is not free to work “automatically” (not apart from monetary policy, for existing institutions do not allow the actual quantity fully to accommodate itself to changes in the demand for money at the existing price level). Mechanism 2, the price response, does not work because money lacks a price of its own. Mechanism 3, diversion of demand, does not work because money supply and demand do not exhibit their imbalance on a specific market from which excess demand might be diverted. (Besides, what would diversion mean for the medium of exchange itself?) Because money is the medium of exchange, excess demand for it is not clearly apparent. Everyone can obtain as much money as he thinks he can “afford” to hold under his circumstances by restraining his purchases, if not by eagerness in selling whatever he has for sale. (A depressed level of income does affect how much money people think they can “afford.”) Market difficulties appear to pertain to sales of goods and services, not to money.

With none of responses 1, 2, and 3 operating, the market process of reequilibrating money’s supply and demand has to be the roundabout process of adjusting innumerable prices and wages on the individual markets for goods and services. For reasons already noted, prices and wages cannot immediately jump to their new equilibrium level and pattern. Meanwhile, transactions, production, and employment suffer.

The supposed problem of oversaving boils down, then, to monetary disequilibrium. Unsurprisingly, what looks like oversaving—a general deficiency of demand posing an economywide impediment to transactions—is connected with the medium of exchange, which is also, in our current system, the medium in which prices are correctly or incorrectly set or adjusted or left unadjusted.

Suitable monetary institutions and policy might avoid macro disco-ordination involving saving and investment and a general deficiency or excess of demand for current output. By themselves, however, they cannot ensure both that a proper share of current income is saved and devoted to capital formation and that resources are properly allocated among capital-construction projects by economic sectors and by degrees of remoteness from final consumption. Nothing can ensure such ideal results—and the very meaning of “proper” in this context is unclear. People do not have perfect foresight, so some capital-construction projects are bound to turn out, in retrospect, to have been unwise, while others will turn out to have been worth expanding. Furthermore, nothing guarantees that the proper share of income will be saved and invested or, in other words, that “society” will discount the future at the proper rate. (These are inherently fuzzy concepts anyway; and again, it is pointless to blame reality for being real.)

Still, avoiding monetary disruption means avoiding a major obstacle to the functioning of the price system. Undistorted by monetary influences, the interest rate is free to play its coordinating role, along with other prices. A well functioning price system allows people to use their own decentralized knowledge and judgments in allocating their resources between current consumption and investment to achieve greater future consumption. Monolithic central decisions that might turn out monstrously wrong are avoided. Entrepreneurs whose judgments turn out consistently sound will acquire greater control over resource allocation than those whose judgments turn out consistently mistaken. Even if the inherited array of capital goods does prove at any time to be what hindsight deems a mistake—as inevitably it will to some extent—market signals and incentives will help promote an efficient use of this array. The bond and stock markets play a role in mobilizing information and in facilitating recombinations of the inherited complex of capital goods. A stable unit of account would aid these market processes and the economic calculation that they presuppose.

CAPITAL AND INTEREST

Recognizing the time element as they do, Austrians give great attention to capital and interest and the importance of saving and investment for growth of productivity and real incomes. Understanding that branch of theory is essential to understanding even the basics of economics, especially microeconomics and the logic of a price system. Böhm-Bawerk and writers in his tradition have made indispensable contributions here.

Keynes saw investment spending as a strategic part of the total spending that sustains economic activity, but he did not treat what capital goods are built or not built as a crucial issue.

Monetarists certainly recognize the importance of capital and interest theory. Unlike some Austrians, however, they do not see it as a dominant strand of explaining the fluctuations of boom and recession. Similarly, although a disequilibrium pattern of relative prices and wages is important in some contexts, it is not central to explaining cyclical fluctuations. The centerpiece of the monetarist story, instead, is a disequilibrium relation between the nominal quantity of money and the general level of prices and wages. Crucial here are the factors determining the quantity of money and the demand for cash balances.

Central-bank policy has much to do with determining the quantity of money. Trying to keep a target rate of interest below the “natural” rate that would otherwise clear the credit market entails expanding the quantity of money, as Knut Wicksell explained; and (less familiarly) trying to keep a target rate above the natural rate involves shrinking the quantity of money or slowing its growth. True as all this is, however, it does not elevate capital and interest theory to the crucial role specifically in macroeconomics that some Austrians would accord to it.

A QUESTIONABLE BUSINESS-CYCLE THEORY

Partly for such reasons my enthusiasm for Austrian economics does not extend to a theory propounded by Ludwig von Mises and F.A. Hayek early in the twentieth century and still recited by some Austrians as the dominant strand of their macroeconomics. The theory blames recession on a preceding policy of excessively easy money. Artificially low interest rates falsify price signals, exaggerating how much saving is freeing resources from consumption for real investment. The false cheapness of credit lures entrepreneurs into otherwise unattractive long-term-oriented, interest-sensitive projects. In time the scarcity of saved resources for completing uncompleted projects or operating completed ones forces abandoning some of them. Demands for complementary inputs and factors of production, including labor, fall off. The downturn arrives. Nothing can be done about the misallocation and waste of resources except to restructure some of the mistaken projects for whatever alternative uses can be found. The lesson about not repeating the easy money that may have caused such distress is often, sadly, not taken to heart.

This scenario, although conceivable enough, finds little historical support. Overambitious investment projects are typically abandoned or restructured not for lack of real resources to complete and operate them but from disappointingly weak demand for them and for the goods and services into whose production they were meant to enter. Consider gluts in the past several years of fiber-optic cable and of houses and high-rise condominiums.

Strands of the Austrian business-cycle theory may well belong in the tool kit of theories that researchers may draw on in investigating historical episodes. Overemphasis on it, however, is an embarrassment that the Austrian school would well be rid of. (For a fuller critique, see Yeager 1986/1997, pp. 229-235.) Excessively easy money can indeed do damage in various ways, but justified warnings against it had best not be tarred by association with a questionable one.

INSTITUTIONS

Not everything said here is standard Austrian economics. It does fit in well, however, with several leading traits of the Austrian school—its emphasis on the coordination problem, its forthright perception of messy reality and the scope it leaves for entrepreneurial activities, and its putting money and time at the center of macroeconomics. One further trait is concern for institutions. It contrasts in this respect with the hyper-free-marketry of the New Classical and real-business-cycle schools, which have cultivated analysis of abstract models uncontaminated by institutional detail. Austrians practice comparative-institutional analysis, which does not mean comparing the real world unfavorably with the Walrasian vision of general equilibrium. When told that reality is unsatisfactory in this or that respect, Austrians are inclined to ask, “Unsatisfactory compared to what?” Like members of the Public Choice school, Austrians know better than automatically to regard government as superior to private enterprise in accomplishing various tasks.

The aggregate-demand/aggregate-supply analysis still dominating the textbooks almost invites itchy-fingered attempts to fine-tune the macro-economy. The Austrians’ concern with fine-grained specialization and the task of coordination directs attention, by contrast, to the question of what framework of institutions and of more or less steady policies, institutionalized policies, can best allow market processes to operate.

The Austrian concern with institutions shows up in the debate over economic calculation under socialism and capitalism and in discussions of monetary standards and monetary reforms. It shows up in the attention that Ludwig von Mises and Friedrich Hayek paid to history. Distinguishing between theory and history, they warned against misconceiving of economics as numerical aspects of recent or earlier economic history. Aware of how important and how changeable institutions are, Austrians are skeptical that a country’s economic “structure” can be pinned down econometrically in functions of stable form and with stable coefficients. Nothing can fully substitute for insights from history.

APPRAISAL AND OPPORTUNITIES

The large institutional and historical element in macroeconomics bars a specific general theory and any well-specified model of the macroeconomy. Emphasizing that element may seem antitheoretical, uninformative, and sloppy; but if that is the way things are, supposing otherwise sabotages understanding. Scarcely conceivable progress in macroeconomics might some day change that condition, but meanwhile we must acknowledge the contrast between micro- and macroeconomics.⁶ Devising a general theory is as difficult for macroeconomics as for diseases and wounds of the human body.

In policy, also, a realistic macroeconomics might seem deficient. Unlike what a well-specified model might seem to do, it cannot grind out specific recommendations, especially not quantitative ones. The best it can recommend to policymakers is to avoid disrupting an economic environment that facilitates the coordination of private plans. What history particularly warns against is disruptions from excessively contractionary or expansionary monetary policy. The case for dependability in monetary policy—for rules, not episode-to-episode discretion—deserves attention.

Macroeconomics gives scant specific guidance for remedying the fears and uncertainties of late 2010. It is true in principle that a monetary policy even more expansionary than already adopted could revive spending by offsetting the fall in money’s velocity—by gratifying the temporarily intensified demand to hold money. Unlike many earlier recessions, however, the current one is not marked by monetary tightness. To ease money and credit further would aggravate the “exit-strategy” problem for the Federal Reserve, the problem of how safely to reverse the great expansion of its balance sheet. Furthermore, such a short-run-oriented expedient might well destroy the Federal Reserve’s hard-won reputation as guardian of the value of money.

In summary, Austrian economics, including macroeconomics, recognizes how messy (“imperfect”) reality is, with so much depending on radically decentralized knowledge and decisions to be coordinated somehow. Decisions are guided, not only by current conditions but also by changing experience, theories, entrepreneurial spirit (Keynes’s “animal spirits”), intuitions, and hunches. Austrian emphasis on the subjective element is amply warranted. Fortunately, attention to the psychological contagion of speculative booms and paralyzing fear is gaining academic respectability.

This cannot all be formalized and rigorized in the way sought by mainstream economic models, with their functional forms and specific parameters informing ambitious and successful policy. Perhaps remarkable intellectual advances will some day satisfy such aspirations. Until then, however, theory and policy must remain modest.

The current disarray in macroeconomics and the exaggerations of lately fashionable free-marketry give Austrian economists an opportunity to earn the attention of the mainstream. In business-cycle theory, their broad time-and-money orientation holds more promise than their specific application of capital and interest theory criticized above, which may have seemed more plausible under certain past historical-institutional conditions than it is in general. Austrian macroeconomics has much in common, and could develop still more in common, with monetarism, with work like that of Clower and Leijonhufvud and Howitt, and even with New Keynesianism. (We should not be afraid of mere labels, which have been especially misapplied in recent years anyway.)

Rising Austrian economists might well find dissertation topics in the areas of monetary history, monetary reform, alternative market institutions, ⁷ property rights, and institutional and entrepreneurial history. A search for historical episodes of depression or recession of entirely nonmonetary origin and character could be instructive, whether or not any actually turn up.

Going beyond preservation and transmission of cherished truths, Austrians can exploit their insights to help gain new knowledge and sounder public policy. Macroeconomics as recommended here may offer governments unfashionably little specific advice, little numerically definite, little beyond warning against monetary disorder and against otherwise contributing to uncertainty and fear. But if that is the way things are, what else can one say?

Austrians can also point out the absurdity of our undefined fiat dollar, whose value rests precariously on nothing better than the changeable policies of the Federal Reserve, badgered from all sides with contradictory, changeable, and short-run-oriented advice. They have much to say about how this monetary anomaly abets irresponsible government, reflected in persistent budget deficits. It is unnecessary to identify sound money exclusively with a particular commodity standard of relatively brief historical duration. As F.A. Hayek and several younger Austrian economists have shown, several alternative monetary reforms are of theoretical and practical interest.

REFERENCES

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^*Originally entitled “Austrian Themes in a Reconstructed Macroeconomics,” this chapter derives from a conference presentation in Amsterdam, January 1995, published in Austrian Economics in Debate, eds. Willem Keizer et al. (London and New York: Rout-ledge, 1997): 22-41. It is considerably updated here.

¹Some might consider this characterization unfair. For an enthusiastic textbook treatment, see Wickens 2008.

²Léon Walras did not postulate the auctioneer explicitly; that secretary of the market, possessing prodigious informational and calculating abilities, is an invention of interpreters. See chapter 1, note 3.

³Mises is only one of many economists who since long ago have recognized price stickiness. The notion that attention to it is distinctively a contribution of Keynes is just wrong as history of economic thought. See my 1991/1997.

⁴Roger Garrison objects to the term “sticky prices” on the grounds that stickiness implies some sort of defect, as of a valve. Perhaps, then, the term “dependable prices” would serve better.

⁵I may seem to give unsuitably less attention to inflation than recession. The reason is not complacency; on the contrary, I am something of an antiinflation hawk. The reason is that the theory of money and price inflation is straightforward and well understood. Incomprehensibility is not the reason why impecunious governments so often disregard it.

⁶For an appeal for due modesty in macroeconomics by an eminent mainstream economist, see Summers 1991.

⁷Peter Howitt recommends studying how real-world institutions function very differently from the centralized Walrasian auction (1990, p. 51). “Further progress will depend upon supplying institutional detail... , including the inventory-holding, advertising, negotiating, inspection, and even price-quoting services of intermediaries and other market-making institutions of real life” (1990, p. 19).