Monetary Disequilibrium Theory: An Unstable Foundation for the Theory of Free Banking

0:00This is a vast field, monetary disequilibrium theory and free banking, and in my 17 and a half minutes, I just want to cover or concentrate on one area. So what I'd like to argue is that the claims of the monetary disequilibrium theorists with respect to free banking have nothing to do with monetary disequilibrium. In fact, it might even be more strongly stated, they don't really have anything to do with money at all. So let me start with just describing the argument that is made. I've taken this from George Selgin's paper on monetary equilibrium and productivity norm.

0:48So the argument goes like this. The problem starts because there is no separate money market in which money demand and money supply can clear. And because of this, if we have excess demand for money, if money demand exceeds the money stock, then there would be deficient, effective demand for goods or under consumption. This generates losses and then sets in motion a depressing effect on the economy. If the money stock exceeds money demand, then there's excessive effective demand for goods, and we get profits and then a boom period. So monetary disequilibrium sets in motion macroeconomic fluctuations in this argument, which can be offset by a regime of free banking in which changes in fiduciary media exactly really accommodate changes in money demand, so money demand increases and then fiduciary media would increase and counteract any depressing effect.

1:53The other part of the argument, which I would again claim is the central core of the argument, is that the changes in prices necessary to accommodate changes in the money relation without free banking do not occur in a timely manner. Price Stickiness No entrepreneur has incentive to lower his price of output and demands for inputs first because of the diffuse nature of changes in the money relation. No entrepreneur wants to absorb more of the decrease in the price of his own good than would be necessary to account for the general increase in the purchasing power of money. George Selgin also says that, he puts it a different way, he says the entrepreneur can't tell a general change in the demand for his product that comes from a change in the demand for money from a change in the demand from his product that comes just from a change in demand for his product alone and so it confuses him and he can't see the difference.

3:01Okay, so let me start with this concept of monetary disequilibrium. I've taken these quotations from Steve Horowitz's book, Microfoundations and Macroeconomics. This is the claim he makes that I made at the beginning. There's no unnecessary relationship between monetary equilibrium and general equilibrium. Here I think is the correct way of looking at this. If we have a system in general equilibrium, we can depict it in one of two alternative ways. These are simply alternative methods of describing the same thing. We have a single coin of general equilibrium that we can describe either on the obverse side or the reverse side. The obverse side would be the set of goods, the left-hand graph. The obverse side would be the money market.

3:46So these are just, again, alternative ways of saying the same thing. There is no necessity of having a separate money market because these two things are either simultaneously in equilibrium or they're simultaneously in disequilibrium. There's an exact relationship, in fact, between the goods market and the money market, contra Horowitz. Now, they may respond to this sort of thing by saying, well, that's not exactly the crux to the argument. Maybe we could go along with this and it wouldn't disturb our claim. So they go on to this other argument. Horowitz puts it this way, that the key claim of the study is that monetary disequilibria and the monetary equilibrium manifest themselves through disrupting the informational properties of price.

4:32If the monetary system is not sound, that is, if it's not free banking, then monetary calculation is less reliable due to the noisy influence of monetary disequilibria on prices. So there's something like relative prices among the goods and then there's monetary prices and the monetary prices introduce noise into the price signals. But again, I think the response to this, the correct way of viewing this is simply to remember that these prices are all determined by preferences that people have. And so all we have at the beginning that sets in motion the causal effect that we see in prices is we have people who have preference ranks where they're ranking goods against money. And notice, if they change then, and money is ranked higher than goods, we cannot tell whether this came from the good side or the money side.

5:24There is no point in discussing this. There is no point in trying to disentangle these two. They can't be disentangled. It's always money is valued relative to goods. And so, as we move from the left to the right, we're describing simultaneously again, or we could describe this as either an increase in the value of money relative to goods or a decrease in the value of goods relative to money. So there's no distinction here to be made. The next thing that I'd like to, the next level of how this argument proceeds, again we can see from Horowitz's book. So he might say, well, okay, that's not really what we mean, that, you know, that's not that important, let's go on to something else.

6:13If money is insufficiently supplied in comparison to demand to hold it, then we're unable to translate our productivity, what he calls notional demands, into effective demands. So the idea here is that when our demand for money increases, since it's not directly demand for goods, Then it can get sort of bound up in hoarding and it doesn't express itself as demand for goods, per se. Now, it seems to me, though, if that were true, I would dispute that it is true, but if that were true, then the solution would not be the regime of free banking that they argue for. It would be a system of commodity money, because then money, in fact, would be a good. And when money demand went up, it would increase the price of a good. and it would set in motion increased production of the good, the commodity, money, and then again we would have no distinction, right, there would be no difference between an increase in demand for money and an increase in demand for other goods.

7:13Okay, so they're not done yet, they go on with another claim that they make about how the real problem is that when money demand increases its effect is diffused through the the whole economy, and that causes the problem relative to when goods demand increases, that's just limited to the goods market itself, to a limited number of markets. So the real problem is money is general and its effect is felt all at once, all through the markets, and goods changes are just felt in one market or in limited markets. But again, this doesn't seem quite right to me. If that really is the argument, then this ill effect of increasing demand for different things, it sets in motion a deflationary depression, would depend solely, not on money, but solely on the saleability of goods.

8:06If the saleability of goods was widespread, well, then it would have this widespread effect. Money is just the most saleable good in the market, right? But there are other, generally saleable goods, In order to put the problem on the other side of the coin, it's certainly possible that an increased demand for money could be restricted in its obverse effect to just a few goods. I can increase my demand for money and reduce my demand for just one good. It doesn't have to be diffuse, right? Again, it doesn't seem to me to have anything to do with money. Okay, so the next line of argument that they suggest is that what they really are saying is that if we could conceive of money as being kind of a neutral element where the demand for some goods goes up and the demands for other goods go down, but they sort of move around money, then we would not have this effect.

9:09So here, I would depict it this way. Let's suppose we have, you know, demand or preferences this way, and then they just switch order around money, so money is staying in the middle, and they would say, this is fine, this sort of thing is fine, but again, I would say, well, I don't think this is fine with respect to the argument they make, because they claim again that when prices, when we have falling demand in certain markets, and so on. It's prices start to go down. And entrepreneurs don't know how to respond to this. They're not sure whether this is noise or whether this is change in relative prices and so on. They can't distinguish this. And so we would get the same problem here, right? We'd have falling prices in the Apple market and related markets here and we'd have rising prices in the orange markets and markets related to that.

10:01And these two things don't somehow offset each other. They would just put in motion a depressing effect along the lines of the argument they make about price stickiness and so on in the Apple market and the related markets. So then they say, well, okay, maybe that's not exactly what we have in mind. Maybe what the real argument is, is that it's just a balance of falling prices. So maybe what really happens is when we have money changing in demand, we get overall prices, We get more prices falling than we get rising, and that's what causes the problem, so we can leave this suggestion. But it seems to me that if that's correct, then the problem that they describe about price stickiness is actually worse, the narrower the scope of the decline in prices in the markets where the prices are declining.

10:56So let's just think through the adjustment process. This is the chain of falling prices if demand for something goes down. So we know what will happen, right? If we get falling demand for output, then revenue for selling the output has to go down. So we start, let's say, at point A, the midpoint of this original demand curve. The price is P. There's certain revenue, you know, P times the quantity. If demand goes to the left, then at this price, at P0, obviously the revenue will be much lower because the quantity is reduced. The people actually buy less, and so the revenue is reduced. And so with the entrepreneur, the entrepreneur's proper strategy, of course, is to lower his price, to re-maximize his revenue with the lower demand.

11:41But in any case, his revenue is lower, so that we know for sure. The lower revenue, then, requires him to reduce his demand for inputs. He doesn't have any choice, right? He doesn't have as much money as he did before. So his demand for inputs has to fall. It's not a question of, there's no other issue involved, right? He just has less money, and so it has to go down. And then the question becomes, well, when he lowers his demand for inputs, the negative effect on his ability to buy inputs in his production depends upon how narrow or how broad this effect of falling prices is. And my contention would be, if the fall in prices is just for his product, then he's in a much worse position than if it's very broad, just the opposite of what the monetary disequilibrium theorist would say.

12:33So if his demand goes down and now he tries to buy his inputs, but all the other entrepreneurs in this market, their demand for their products has stayed high, he will not be able to bid resources anymore, he can't pay lower prices and bid the resources he needs away from these These are the guys whose demand hasn't fallen, and so he's in a worse position. He has to cut his production, investors would disinvest in his production process. And whatever one might say about the prisoner's dilemma character of this situation for the entrepreneur, the outside investors who decapitalize him or capitalize him are not subject to this prisoner's dilemma. They're just going to pull their money out and his production will collapse. Now the broader the decline in prices, the better his position is.

13:20So if all the demand for all of his competitors in one market is falling, then when he goes to buy his inputs with his smaller demands, he'll be able to maintain his buying of these inputs. If the demands are falling throughout the economy, he's even in a better position because then he's buying inputs that are even more, I should say, less specific to his production process and he can still buy those too. So again, I don't think their argument is correct here. George Selgin again has this variation where he says entrepreneurs can't distinguish between declines in demand for his product alone and declines that are general because the demand for money has gone up, declines in demand for his product. But again, we just think about what happens to this guy, that doesn't matter, right?

14:08His best strategy when his demand goes down, for whatever reason, is to lower his price Price and re-maximizes revenue at the lower price. He has less revenue, his demand for inputs has to fall, and so economic calculation still works in this instance. Okay, now let me get to the very last point I want to make is on price stickiness, and again I'm not presenting a full argument here, I just mentioned I think monetary disequilibrium theory then at its core is just an argument about price stickiness. I don't think money Money has anything to do with it, or it's certainly monetary disequilibrium has nothing to do with it. So this is what Horowitz says about the speed of adjustment of prices, if they're unable to fall with significant speed, in the face of the excess demand, this creates the economic decline.

14:54But again, I would say first in response to this that if this were true, then this effect would occur if the demand for goods goes down too, and this has nothing to do with money. It just has to do with the stickiness of prices. The other thing to say about this is that the speed of adjustment of prices to changes in demands is an entrepreneurial choice, it's an entrepreneurial strategy. So some entrepreneurs are in markets where their customers want prices to change a lot, they want them to change instantaneously like in financial markets and then there are customers in other markets who don't want them to change. Every second as they're in retail stores as customers we don't want the prices to change and so the entrepreneurs to get the, you know, to maximize their profits and service our preferences leave prices the same. It's their policy to have the prices sticky. Wage contracts are the same, right? The entrepreneur forms a wage contract with the worker and price

15:48stickiness is built into this contract consciously by the two parties. The workers want fixed wages and the entrepreneur is willing to accept this uncertainty on the basis of this. And then the last thing I would say in response to the price stickiness is this is why entrepreneurs hold equity. They hold equity so that in the face of falling demand for their product, they can absorb some of the losses in the interim period when they're trying to figure out what's going on in the market. Is this a general demand, is this just specific to my good, how am I going to adjust to this? Well, they accommodate these sorts of things, again, in their normal business strategies. Okay, so at this point I'll stop.