Recession Economics and Non-Neutral Money

0:00My paper is not so much on money per se, but more business cycle type stuff, and the distinguishing characteristics that separate Austrian macroeconomics from the other types of macroeconomics can be found in one, heterogeneous capital, and two, the use of non-neutral money. And the Austrians have been very good when it comes to explaining the negative consequences of Monetary Expansion So, what does it do? Well, first of all, it erodes the purchasing power of each monetary unit. Monetary expansion changes the relationship between debtors and creditors. There's a signal extraction problem that's created. In other words, price signals are jammed.

0:45And if we're not careful, hyperinflation can come about. Now, most economists agree with these first four points, and here's where the Austrians add. There are non-neutral effects of monetary injections, and there are real wealth changes that occur because of it. And also, it can lead to a business cycle. So, the importance of non-neutral money is explained by Mises in his article, The Non-Neutrality of Money, which he presented in 1945 and also 1938, and is in Money Method and Market Process, and he says this. says, I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money. Money is non-neutral or it does not exist.

1:32Well, that's a pretty powerful statement there. So I assume that this applies when the monetary supply expands and also with monetary contraction. We can't just, you know, look at it when it expands, but we also have to assume that money is non-neutral when it contracts. So when When we see monetary expansion, we see that money is injected at specific points in time and given to specific people and given to specific institutions. And when it does, each injection creates a unique pattern that's different each and every time. So if the Fed gave me ten million dollars today, I would spend it very differently than if they gave it to me a year ago or five years ago. And we see what happens as a result of this.

2:17The people who get the new money first win, and those people who get the new money last lose. And Austrian economics has talked about this over and over again. I think we've got that story down correctly. So then that brings us to the business cycle, and so we come to the upper turning point. What are the features of the upper turning point? Well, we see there's credit contraction, we see that there's rising interest rates, and we see that there's rising input prices. So the money supply can be contracted through exogenous forces where we have the central bank slamming on the monetary break, we can see it coming through endogenous forces where we have failures and bankruptcies of businesses and banks and that contracts the money supply, or most likely and usually the combination of the two forces.

3:07So let's look at the first one, the exogenous central bank. So what are the tools of the central bank? Well, we've got the central bank is able to set the required reserve ratio. It has the ability to encourage or discourage the banking system's acquisition of borrowed reserves. Now, a year ago, all I would say is it sets the discount rate, but they don't do that anymore. And then also the conduct of open market operations, the power to expand or contract the amount of non-borrowed reserves. So this is standard money and banking textbook stuff. It shouldn't surprise anyone. But the upshot of all of this that I want to draw your attention to is that for contractionary monetary policy, each tool results in the reduction of credit and loans. Now endogenous business failures are just basically businesses failing. And when they fail, they default on their loans, the banking system will face capital adequacy issues and therefore these banks are also going to fail. The collapse of a few banks could generate a contagion

4:15effect, it will cascade like dominoes, and many banks will implode, so the total amount of credit and loans shrinks. So what's the implication of this? Well, Mises is quite clear on this in Human Action, he says, the monetary contraction hurts all enterprises, Not only those which are doomed at any rate, but no less those whose businesses sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom.

5:01and this is what we call the secondary contraction, this is the thing that Hayek and Lionel Robbins were all upset about. So what then happens then after we turn that upper turning point, we start contracting? Well tracing the effects are not that easy, right? It's not just simply reversing the numbers or reversing the changes, it requires a separate step-by-step analytical process and and so we just can't just roll it back and and Mises has a wonderful quote and apparently Senholtz talked about it and then Larry Reed brought it up on the first day he said it's like when you run someone over with a car you're not going to help them out by throwing it in reverse and running back over them so we have to we have to analyze what happens here and Rothbard then says well the crisis this isivid man economy and states The crisis is often marked not only by a halt to credit expansion, but an actual deflation, a contraction of the money supply.

6:03The deflation causes a further decline in prices. Any increase in demand for money will speed up adjustment to the lower prices. Now, while in general it may be true that these prices fall, we cannot make the leap to say that all prices fall, because non-neutral money has to work both ways. The prices are the signals of relative scarcity ratios and any falsifying or jamming of the price signal creates market misallocations. Some of these market misallocations will manifest as projects that use capital equipment and as such should also be termed malinvestment. If you look at some businesses, they're counter-cyclical. Like what? Mount Olive College. What are we doing? We're getting big enrollments now because people are losing their jobs, they're looking for something else, and we're going in building new dorms, and we're building this, we're building that. That's malinvestment. It's okay, but no one on the faculty will watch this here. I hope. It's on YouTube, right? Not yet. Back to Rothbard. Rothbard will always

7:20So what does Rothbard say? He says furthermore deflation will haste an adjustment in yet another way. For the accounting error of the inflation here is here reversed and the businessmen will think their losses are more and profits less than they really are. Hence they will save more than they would have with correct accounting and the increased saving will speed adjustment by supplying some of the needed deficiency of savings. Now notice that a systemic entrepreneurial error emerges emerges from the secondary monetary contraction. Rothbard argues that the adjustment caused by the incorrect accounting leads to a faster adjustment with an increase in savings. While his analysis may be correct, this increase in savings or forced savings is also a misallocation of resources. The consequence of this incorrect accounting is that the economy overly contracts.

8:19It seems that economists and policy-setters face a trade-off between the length of the recession and its depth. In a recession, the central bank has three courses to choose from. It can do nothing and not interfere in the liquidation process. It can actively contract the money supply in the hopes of accelerating the correction of the past malinvestments. and, finally, it can engage in expansionary monetary policy to counteract the deflation of the money supply and prices. So, it can either do nothing, it can bring the money in, or it can try to stop the deflation by pumping more money out. So, non-interference, or maybe technically it should be no further interference, by the central bank.

9:07of the Central Bank. The recessions are processes of liquidation that clean out the malinvestments that were built up during the artificial boom. During this phase of the business cycle, credit is constricted and profit margins fall. In a recession now, people are hurt, real people we're talking about, more than they would be if there was no secondary contraction. So the secondary contraction is this extra pain. And it's something that we need to to keep in mind, especially when we're talking to people beyond just academics, because they not just think, they feel, and they go with their gut, they go with their heart. And some entrepreneurs whose businesses would not have normally failed, do fail, due to the larger macroeconomic situation, right? The big wave just knocks out a whole bunch of businesses.

10:00So this secondary contraction is what caused Hayek and Robbins to lament that they did did not advocate a policy of monetary expansion. The transformation of savings into new capital and realignment of production methods to this new reality is a slow process because we've got to throw stuff away, we've got to change the structure of production and it's not going to be a quick fix. So during this time, hurt and hardship are endured by real, living people. The failure to sufficiently emote on this point has caused the free market economist to be portrayed as without a heart. Such portrayals do not win over the setters of policy. Thus the economist is asked for a do-something policy.

10:49So, what do we do? Well, let's suppose that we encourage the central bank to deflate, to contract the money supply in the hopes of accelerating the end of the downturn, right? You want it short and sharp. Now, the deflation choice might be something that a reader of Rothbard, Salerno, and Holzman might contemplate doing. Well, now why is that? Well, although none of the authors advocate a policy of monetary contraction in the middle of a recession, I talked to Guido before this, he said, no, I don't do that, or actually in German, you know, no, I don't do that. Such a policy may be inferred from statements claiming that, quote, no harm will be done by deflation. It is benign. It benefits taxpayers through the process of rabatrage. There is no reason why this redistribution from deflation should have negative consequences for overall production. Bankruptcies do not affect the real wealth of the nation, and deflation appears as a great harbinger of liberty. Now, why someone might infer that deflation is a good

11:57Rothbard and Holzman both recognize that there will be redistributional effects generated from monetary contraction. However, I believe they both consider the benefits to outweigh the negatives. Setting aside issues of justice and comeuppance, Rothbard is taking a normative position that cannot be supported by theory. His position is that the harm to those caught up in the overshooting of monetary and economic contraction is outweighed by the increased speed by which the economy bottoms out and begins recovery. While one may personally agree with this trade-off, shorter and deeper versus longer and shallower, Rothbard cannot make such an interpersonal utility comparison. And when Holzman dismisses the redistributional by arguing that they cannot be avoided, seems to be ducking the issue.

12:59These redistributions would create malinvestments, which would need to be liquidated in the future date. When I was driving over here, and we were just north of Charlotte, we got stop and stop traffic. Not stop and go, but stop and stop, and we were like, what's going on? And eventually when we got to the end of whatever the problem was, there was a sign that said, merge left. Road Construction Ahead

13:53If policy-setters were to follow this advice and direct the central bank to actively engage in a policy of monetary contraction, how would it be accomplished such that only the funding of malinvestment was withdrawn? Nobody knows. How do you do that? Nobody knows. And obviously, this is an impossible task. With redistributional effects present, pulling money out of the banking sector would make them the biggest losers. Ha-ha! Take that, banks! But what needs to be liquidated is not redistributed wealth, but the malinvestments that were built up during the artificial boom. If we consider the banking system is in large part a pass-through of new funds, then redistributing wealth away from the banking industry will not liquidate the malinvestment. Instead, the distortionary effects are compounded.

14:40Prices are being falsified, resources are being misallocated, and capital budgetary Monetary expenditures are enacted on the basis of these false prices. So then what? Well, we could encourage the central bank to reflate. So Solzhen in less than zero and Hayek in 75 and Robbins in 71 support the productivity norm as a standard for the conduct of monetary policy. As a policy goal, they wish to keep nominal income constant, thus when people decide to To hold on to more cash balances where we see a drop in V, there should be an expansion of the money supply to offset this contraction. To accept this policy recommendation, the question of what would it take to nullify the effects of a decrease in V, well that needs to be answered.

15:29When people hold on to more cash balances, the nominal money supply contracts and there is a decrease in demand deposits and less credit. The money that is injected into the economy must go to only those enterprises that are are contracting from the secondary contraction, but not to those malinvestments that were built up in the initial credit expansion. Now how do we do that? Well, I think meeting such a condition is, of course, impossible. There's no method by which one can recognize ex-ante which projects are malinvestment and which projects are not. The expansion of the money supply, regardless of intent, has the same six consequences outlined above, and it does not matter whether the economy is moderately growing or in recession. The trade-off between depth and duration ends up being a false one.

16:17The malinvestments will eventually need to be liquidated. Each injection then causes additional misallocations of resources, builds up malinvestments and prolongs the suffering of those in the economy. So what do we do? Well, the central bank policy-setters have three options open to them. The option of non-interference leads to a secondary economic contraction, and that's unfair and unjust to those living in the midst of a recession. The policy of monetary contraction overrules market preferences and deepens the secondary contraction in the hope that it will be over more quickly. While the theory does point to the possibility that a recession may end sooner, it's not guaranteed.

17:03is certain that accelerating the secondary contraction will lead to more significant overshooting and thus economic hardships. Then the third policy then, choice of monetary expansion, attempts to avoid the pain of economic contraction, but it also avoids solving the problem of malinvested capital equipment and misallocated production structures. At best it delays the solution, at worst it makes the future economic hole deeper. Thus we're back to the policy of non-interference. It's It's a terrible policy for the central bank to take. However, it's better than its alternatives. It should be remembered that the hardship endured under a non-interference policy does not stem from the policy itself, but from the fact that we're in a recession. When malinvestments are built up during the previous expansionary monetary policies, recessions are the necessary consequence. It's like going to the dentist. Having a cavity sucks, it's not fun, but you We've got to drill it out. Recessions are terrible economic events, but are necessary for the overall health of the economy.