Capital, Monetary Calculation, and the Trade Cycle: The Importance of Sound Money

0:00Southern Economic Association meeting, there were two non-Austrians that were presenting a paper on what Austrians should do in the future to be better accepted. And one of their suggestions is that we quit quoting Mises, Hayek and Rothbard so much. So I thought that instead I would quote Salerno and Betke and Lewin and Walter Block. But on the Mises lecture, there's just so much in Mises that the paper is full of quotes by Mises. But given the Rothbard seminar yesterday, Peter Betke did make me realize that if there is anything significant and original in this paper, paper. It probably really did come from Man Economy and State and it hasn't been cited. So and one of the nice things about this conference is there's so much going on intellectually that you can learn and add to your presentation and from Robert Higgs this afternoon I learned a lesson here that if you're If you're going to be boring, at least be funny.

1:21Now, the problem is, is that while I know I can be as boring as Bob was, I doubt I can be as funny. And then a couple of caveats is that my wife has had the pleasure of hearing this lecture perhaps one more time than she would have preferred. and she did tell me to give you a suggestion on how best to listen to the presentation and so now is the time to take out your video poker games and just kind of periodically look up and nod approvingly and then just to put questions because I know there's many young Austrian scholars here And there's some of them that when they saw I was going to do this presentation, probably got out the AKC stud books and discovered that I did own a dog named Liquidity Trap.

2:23And with the current controversy with Professor Manchi and his dog, Keynes, I do want to reassure you that this dog had nothing to do to indicate an affinity for Keynesian economics, If any of you have ever been involved in animal husbandry, you know that it had to do with any liquidity you quickly got was trapped into these animals. And so, I'll put that aside. And then, finally, just to put those of you at ease who were here last year for the Rothbard lecture, that I promise I will not use the word eviction in this lecture, okay, other than perhaps in the conclusions when I recommend what to do with the employees of the Federal Reserve after we sell off the buildings to the private sector, okay, and then the last thing I learned early in the profession is the title here is essentially the importance of sound money and Tony Deegan today put the whole speech in a single sentence.

3:35That there's no such thing as honest accounting in a dishonest monetary system. But I'll let you hear the whole 15 pages that will develop this succinct summary of the deal. As Kirzner had pointed out, Mises did not start out to write or develop a theory of the trade cycle. His trade cycle argument first appeared in the last few pages of The Theory of Money and Credit and his early development of the Austrian business cycle theory was a direct manifestation of Mises's rejection of the concept of neutral money and quoting Kirzner emerged as an almost incidental byproduct of his exploration of the theory of banking. This development was an incomplete sketch of the theory, particularly for those not well-versed in capital theoretical foundations of the argument.

4:28In fact, Hayek's first exposition of his version of the theory appears in a long footnote in his 1925 paper, Monetary Policy in the United States After the Recovery from the Crisis of 1920. The note was added following the suggestion from Gottlieb Habler. Hayek explained that since no sufficient exposition of the theory I had used was to be found in Mises' work, and if I was expected to be understood, I must give a fairer account of the theory underlying my report of the events being described. The Austrian theory of the business or trade cycle is an intricate blend of monetary theory and capital theory. Mises and Hayek's monetary and capital theory differs in both significant and subtle ways from, since Pete's not here, I'll say it, the mainstream, neoclassical approach.

5:21Economists working in the Misesian tradition are still plagued by problems of communication with non-Austrian economists. While the terminology used is similar in both theories, the definition of key terms, The understanding of the nature of the economic problem, the role of prices, especially prices for the means of production, differ considerably. Hayek did much of the work developing the real aspects of the business cycle theory, but as has been pointed out by others, particularly Joe Salerno, Hayek had one foot in the Austrian camp and another foot in the Walrasian general equilibrium camp. Now, there's a plus to this. For this reason, Hayek can be an important bridge between the mainstream and Austrian economics.

6:10Hayek can be read, or perhaps more easily read, reading Hayek is never easy, by a neoclassically trained economist with limited background in Austrian economics. In many cases, his insights can be assimilated and at least partially incorporated into neoclassical analysis. But many of the subtleties within the Austrian business cycle theory and the calculation arguments depend on Austrian capital theory and the Austrian understanding of the role of time in the economic process. Those relying on Hayek often interpret Hayekian arguments in terms of neoclassical theory and can be misled to believe, as was Calder in the 1930s, In the 1930s, that Austrian business cycle theory was by no means so intellectually satisfying as it first appeared.

7:03There were admitted gaps here and there in the first published account, which was intended as merely rudimentary, and which when one attempted to fill these gaps in, they became larger instead of smaller, and new unsuspected gaps in the theory appeared. While there is much that is useful in Hayek's numerous attempts to answer his critics, one must go back to his men are Mises and to what Lewin calls modern Mengerian capital theory to build a more complete and convincing response to Calder and similar critics. The response depends on the development of the theory of the market process of a monetary economy. As Lewin explains, while neoclassical and Ricardian capital theory interpret Boehm-Bawerk within an equilibrium framework and focus on his empirical insights regarding the greater productivity of capital using processes, Modern Austrian market process theories, following Mises, Hayek, Lachmann, Kirzner, Rothbard, and also Frank Feder, focus on some of Boehm-Bawerk's less formal pronouncements and draw some crucial insights from them.

8:14In particular, these involve the role of time and the nature of profit and interest. This market process theory leads to an understanding that monetary calculation and capital provide the only basis for rational economic planning. Rational economic planning is the foundation for the development and continuation of civilization based on social cooperation and division of labor. A cycle theory in the development of the monetary calculation argument. Peter Betke has argued that the centrality of monetary calculation to Mises and Hayek is the unique contribution of the Austrian School of Economics. Combined with the additional Austrian assumptions and theoretical propositions, irreversibility of time, uncertainty, time structure production, and heterogeneity and multi-specificity of capital goods, non-neutrality of money, and so on, monetary calculation emerges not just as an aspect of the market process, but the crucial element which allows for social cooperation under the division of labor."

9:29The arguments concerning the importance of monetary calculation for rational economic planning came to the forefront during the socialist calculation debate. The rational economic calculation argument was, however, a development of Mises's early work in monetary theory and his extension to the trade cycle. For Mises and Hayek, the trade cycle theory was an attempt to integrate an understanding of a complex capital structure into a monetary exchange economy. Austrian business cycle theory is based on inter-temporal misallocation of resources. The real inter-temporal pricing problem is the relationship between the prices of inputs applied at an earlier date to the price of outputs available at a later date, the natural rate of interest in the Austrian model, and the market rate of interest in the loan market is influenced by credit creation.

10:27Kirzner, in his biography of Mises, highlights this point as a key element in Mises' theory. Mises, he argues, relies on the reader's understanding, the Boehm-Bawerkian insight, that the money rate of interest simply corresponds in a smoothly running economy at a given level of production to the excess value of consumer goods at a given date over the value, the spot prices, of the inputs invested at an earlier date in their production. In the development of the trade cycle, it is in the development of the trade cycle theory that Mises and later Hayek recognized that rational economic planning involves not only monetary calculation, and quoting Salerno, in the absence of money, there are no economic quantities and no economic calculation, but more importantly, the appraisal of the value of resources available in earlier periods relative to the expected prices of the relevant output available at later dates.

11:33This is the entrepreneurial function and it cannot be duplicated in the absence of market prices or market processes where prices reflect the preferences and judgment of valuing acting individuals. As pointed out by Salerno, the real market process is driven by identifiable though ever changing class of individuals whose productive activities are guided by monetary calculation based upon perpetual forecasting of an uncertain and changing future. The market environment that is necessary to allow this entrepreneurial planning process to function most efficiently is the connection between the monetary, capital and interest rate theory that is the foundation of the Austrian business cycle theory and the development and refinement of arguments advanced by Mises and Hayek in the socialist calculation debate.

12:27The key element in this long, in this enabling environment are private ownership of the means of production, monetary calculation, capital and sound money. Recognizing the role and importance of monetary calculation requires a proper understanding of the economic problem, Which, according to Mises, is to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed, wasted, for the attainment of a want less urgently felt. The very nature of this economic problem is misstated in the standard economics textbook.

13:14The problem is not the allocation of known scarce resources to satisfy known wants of known consumers using the known lowest cost method of production for each and every good and service. These knowns are not given but are the elements that must and can only be discovered through a market process. The task taken on by the entrepreneur is to make profits and avoid losses by attempting to meet the anticipated future wants of consumers in the most efficient way possible. This task is by its very nature speculative. But once one recognizes the fact that life is not rigid, that all things are perpetually fluctuating, and that men have no certain knowledge of the future, then it becomes clear that calculation is as efficient as it can be.

14:15No reform could add to its efficiency. The entrepreneur makes use of a mental tool of economic calculation to adjust his actions as well as possible to the present opinion concerning want satisfaction in the future. For this purpose, acting man needs a method of computation, and the computation requires a common denominator which all items entered are to be referable, and that common denominator is money. Mises summarizes monetary calculation as a method of thinking, quoting Mises again, that A, is a guiding star of action under the social division of labor, where the entrepreneur calculates to distinguish remunerative lines of production from the unprofitable, and B, is a commercial pre-calculation of expected income.

15:09and B is a commercial precalculation of expected costs and expected proceeds and an ex post evaluation of past action as reflected in accounting profits and losses and can operate only in an institutional setting with a division of labor and private ownership of the means of production in which goods and services of all orders are bought and sold against the generally used medium of exchange, i.e. money, and D, it reaches its full potential for perfection in capital accounting. The concept of capital is not a category of all acting, but only a category of acting in a market economy.

15:58Capital is an essential element in entrepreneurial planning. It is an estimate of the market value at a definite date of a particular business plan. As such, again quoting Mises, it cannot be separated from the context of monetary calculation. A given business or entrepreneurial plan implies a time structure production for the individual enterprise, A pattern of inputs, capital goods, labor, natural resources and land, applied at earlier dates, followed by a pattern of outputs sold at later dates. Groupings of entrepreneurial plans imply a time structure of production for the economy as a whole.

16:47And this time structure of production is made up of both interconnected complementary plans and competitive rival risk plans. Monetary calculation, forward-looking capital valuation, and the continuous feedback from profits and losses prod entrepreneurs to continuously adjust plans towards the provision of goods and services most valued by consumers, towards solving the basic economic problem. Without market money prices, and especially money prices for the means of production, there can be no monetary calculation. Without private ownership of the means of production, there can be no market for resources, no money prices for resources, and thus no monetary calculation and no capital.

17:38Without capital, the economic problem is neither calculable nor solvable. The father of the former socialist economies has alerted most economists to the importance of market and private property for long-term economic prosperity. There is, however, an additional important element that is critical if monetary calculation is to operate in a way most consistent with consumer sovereignty. That element is sound money. As expressed by Salerno, while there is now a basic recognition by economists that the rational allocation of resources necessitates institutional reforms that return resources to private hands and restore genuine markets for productive inputs, there is no such comprehension of the importance of sound money to the process of economic calculation. End quote.

18:38What is sound money? Picking on Joe again. Sound money then is simply one which does not lead to systematic falsification or nullification of economic calculation. Economic calculation requires money prices. But for calculation to most adequately achieve the goal of solving the basic economic problem, The money prices used for calculation must reflect the valuation of producer-consumers that are based on their individually unique preferences, knowledge and resources. With sound money, money prices reflect valuation and action. The following types of changes in the purchasing power of money are consistent with a sound money.

19:30These are fluctuations in the purchasing power of money caused from the money side that reflect individual preferences regarding the holding of cash balances. There are also changes in the purchasing power of money caused by valuations that induce individuals to engage in the discovery of and production of the market chosen money commodity. and changes in the purchasing power of money that come from the good side. Such changes in the purchasing power and money are part and parcel of the continuing market adjustment to an uncertain future. For any given market, prices will fail to reflect individual valuations whenever there is a government intervention in the market.

20:22Entrepreneurs can still make plans based on controlled prices, and given the imposed constraints on behavior, such plans may be profitable and thus appear temporarily successful. But such plans are not consistent with the above goal of solving the basic economic problem. While not systematic, yet economic calculation has been falsified. Extensions of the price controls to most or all markets, as in the post-war communism, the 1919-21 socialism, socialist economies, lead to explicit systematic falsification and or nullification of economic calculation.

21:08This type of calculation problem, this is the type of calculation problem that eventually led to the decline and fall of the former Soviet block countries. Sound money is then a money whose purchasing power and quantity is determined by consumer-producer valuation as determined by their preferences, knowledge and resources. A market-determined commodity money absent government intervention, as expressed by Mises, Mises, economic calculation does not require monetary stability in the sense in which the term was used by the champions of stabilization movement. The fact that rigidity in the monetary unit's purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation.

22:02What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. The endeavors to expand the quantity of money in circulation in order to increase the government's capacity to spend, or in order to bring about a temporary lowering of the rate of interest, disintegrate all currency matters and derange economic calculation. Because money has no market of its own, monetary interventions permeate all markets. Monetary interventions and universal price controls create falsification problems that are immediately systematic, but the effects of monetary interventions are much, much more subtle.

22:54Modern economists are united on the goal of sound money, which is one, what Salerno and Rothbard call avoiding calculational chaos, and two, Mises' theory is provide an instrument for the protection of civil liberties against despotic inroads on the part of governments. There is also general agreement that a return to sound money involves abolishing central banking and paper fiat money and restoring a commodity money chosen and totally subject to the market. There is, however, controversy over the means. Does sound money require 100% reserve banking or does it allow banking freedom? Now, I deliberately use the term banking freedom here rather than the more familiar free banking to differentiate those who see banking freedom as consistent with sound money from those who advocate free banking as a means to offset the influence of changes in demand for money on monetary equilibrium and the purchasing power of money.

23:59Banking freedom implies banks operate in an environment where the banks are subject to the general rules of commercial and civil law and are not recipients of special privileges and protections granted by the state. As expressed by Mises, what is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws, compelling every individual and firm to fulfill all obligations in full compliance with the terms of contract. On banking freedom or 100% reserves, the problem does one follow Mises from Human Action, where he argues free banking is the only method for prevention of the dangers inherent in credit expansion.

24:47It would, it is true, not hinder a slow credit expansion kept within very narrow limits on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking, it would have been impossible for credit expansion, with all its inevitable consequences, to have developed into a regular, one is tempted to say normal, feature of the economic system. Only free banking would have rendered the market economy secure against crisis and depression. And, as he concludes, there is no reason, whatever, to abandon the principle of free enterprise in the field of banking.

25:33And then, or does one follow, and I'm going to apply Stiegler's Law here, which is, which is, in Stiegler's Laws, there's nothing in economics named after the first person who ever discovered the principle, which might tell you where Stiegler's Law came from, and I'm going to sense Jeff, I think, this morning homesteaded the principle. I'm going to refer to these as the Herbanarians, so there's another principle. Well, if it's tough to put an IAN on the end of your name, you probably will never do anything significant in economics, okay? Because they just find somebody else who did this, okay?

26:18There's one follow-up, and the group would include Salerno, Pepiner, and possibly Reisman, who argued for 100% reserves on the basis of reform proposals made by Mises, that argued for 100% backing of newly issued notes or checkable deposits. For a reform of a monetary system on the verge of collapse, or as a proposal for how we move from a current system towards a sound money system, such a step may be essential. But after reform though, it is essential that, again following Mises, the question of banking freedom must then be discussed again and again on basic principles. Government control and intervention into the monetary system creates distortions in the money pricing system.

27:10These interventions lead to money prices that are not based on individual valuation and knowledge. Calculation errors will be in excess of entrepreneurial errors that are normal when planning for future provision of consumer wants in the face of unavoidable uncertainty. Planning to meet consumers' most urgent demands is hindered, and in the case of a crack-up boom, where no substitute money is readily available, so shortened in time horizon as to be effectively eliminated. The arguments supporting the sound money policy were originally extensions of the Austrian business cycle theory. Credit creation systematically undermines capital-based entrepreneurial plans by increasing the difficulty associated with, quoting Kirzner, the relationships between resources at one point in time and outputs of subsequent points of time.

28:07The crisis or bust following a boom is just a calculational meltdown cut short. The intervention is stopped or slowed and the falsified calculations are revealed. are revealed. The corrective action of profit and loss feedback begins again to assert itself. Economic activity recovers as the market again begins to align business plans with consumer producers' valuations and available resources. If the intervention is not slowed or stopped, the inflation continues until a cracked up boom sets in with the associated complete calculational breakdown. Sound money provides a financial environment where economic crises associated with misdirections of resources and malinvestment can be avoided, and where monetary calculation can be as efficient as possible.

29:04Economists who accept the Austrian argument on the impossibility of rational economic calculation in a socialist economy and recognize the calculation problems inherent in highly interventionist economies that reject Austrian business cycle theory should re-examine their position. The key elements for understanding the market process based on entrepreneurial planning, monetary calculation and capital are the key elements underlying both the calculation argument and the Austrian business cycle theory. Without sound money, calculation is less efficient, the economy will be prone to business cycles.

29:49With sound money, no boom-bust cycle will emerge, and monetary calculation and planning will be as efficient as possible in an uncertain world. We're open for questions.