Thursday, July 15, 2010

Stable Money, Part 1: The Standard Premise

One of the sticking points for many people in evaluating the merits of the Austrian take on economics is its rather insistent stance that the money supply be as fixed as possible.  Bashing the FED is all well and good -- every intelligent American knows that any bureaucracy which has been granted coercive powers by government needs a healthy supply of tormentors and critics.  But this whole argument about money supplies and gold and bank accounting practices seems to take things off in a rather strange direction and to a rather uncomfortable extreme.  After all, the present money system is fairly well-established, isn't it?  Is it really a good idea to go messing around with it?  These are rather alien ideas that nobody learned in school and almost no other accepted school of thought has even the slightest respect for. 

Less inflation?  Well, okay, that seems fairly reasonable, and most people understand the danger of rapid currency devaluation at the hands of an entity able to manipulate the money supply at will.  No arguments there.  But a completely fixed money supply?  Isn't that a little crazy?  That doesn't sound like it would even work at all.  Doesn't the economy need more money all the time, since both it and the population are growing?  What would happen to prices?  Aren't stable prices pretty important?

Silver, Gold, and the Siren Song of Stable Prices

The funny thing is that as recently as a century ago, that line of thinking, mundane and commonsensical as it sounds, would have seemed rather strange.  The whole idea that stable prices, and in particular, stable consumer prices, were supposed to be an important goal of monetary policy took hold sometime around the 1920's. 

That's right -- it was an important part of the Progressive movement.  Before that time, it was taken for granted that prices would fluctuate and everyone just had to deal with it.  Money was expected to be silver and gold, with banknotes exchanged in lieu of the actual metal.  Central banks and paper money, especially 'unbacked' paper money as was often issued for the purposes of making war, were regarded with suspicion as they had a reputation for collapsing.  And the funniest thing is that despite an utter lack of concern for 'stable prices' so long as money was of silver and gold, for the most part prices were stable.  It is modern prices which are unstable, despite the FED's supposed mandate to 'maintain a stable price level.'  The world turned upside down doesn't begin to describe the irony.

Unfortunately, most people already know all that, won't much argue with it at all, and yet for some reason don't find it very convincing.  It's a tried and true argument that doesn't convince anyone, even though logically it should.

It's Not Fair

Other arguments have more of the right 'feel' to them.  When it is put to a person, "Okay, suppose I accept that the money supply 'needs to grow with the economy.'  Tell me, how should the new money come into existence?  Who should get the new money first?  Somebody has to." 

This immediately brings up issues of fairness. Should people get new money in proportion to how much they have at present?  That seems logical, but evokes howls of egalitarian outrage.  Everyone receives the same amount?  For nothing? Socialist!  Now we are into issues of politics and practicality.

Okay, what if the government just spent the new money into circulation.  It would reduce the tax burden, right? Surely, certain groups would benefit disproportionately, but not too badly, right?  Grrrr...  Government printing money to pay its bills.  Conflict of interest.  Growing government.  This begins to look unseemly.

But nobody would argue that the present system of creating money through credit is even remotely desirable, once one works through the fairly obvious consequences.  That, at least, surely shouldn't continue, right?

Okay, so it would be practically difficult, if not completely impossible, to devise a fair system for increasing the money supply, without bothering to consider any second-order distortions such increases might create.  Further, it is surely true that the present system of rewarding profligate too-big-to-fail borrowers and the banking system is destructive and horribly unfair.  That much is clear, and if one is like most fair minded people, it'll probably get his dander up at this point, with all the going's on of late. 

Lot's of people are mad, and probably willing to consider making a change.  But I'll bet that almost all of them are still unconvinced that an economy doesn't need any more money over time, at all.  After all, there are other conservative, free-market schools of thought that don't embrace such out-of-mainstream wackiness.  Why shouldn't a guy become a supply-sider or a Friedmanite, rather than a hokey Austrian?

The Problem of Premises

The problem here is that the Austrian apologist is arguing against a premise held by almost all other economic thinkers and the public at large, but which his school of thought does not share.  (Actually, there are also a few others.  But those are less important and a bit more obscure.)  It is difficult to get a person to question his premises, let alone abandon them in favor of others.  It is usually much easier to merely convince him that some train of thought was made in error and show the correct conclusion and how to arrive at it.  But even that is usually pretty hard. 

I think this explains the popularity of Milton Friedman and the Chicago school relative to the Austrians.  The average person doesn't need to change his premises to follow this school.  He gets into the free-market club without the pain.  But, if you're like most people, you must alter your premises in order to make the transition to Austrianism.  And premises are tough nuts to crack. 

Persuasion Is Futile

So, I could continue on to show factually that 'deflation,' e.g. falling prices, does not destroy markets by pointing out that the price of electronics and other such goods fall rapidly without any obvious detrimental effects.  I could talk about the infinite divisibility of  money, how ever smaller units could be used to reckon prices with no first-approximation  disturbance to markets any more than constantly rising prices produce.  There is no practical arithmetic distinction between multiplying and dividing when one includes decimals and fractions in the mix; prices might as well 'compound down' as 'compound up' and it wouldn't matter.  This is because most people instinctively recognize what money is for, even if they can't always articulate it all that clearly, and that relative prices are the important thing, not absolute numbers.  Prices slowly drifting one way or the other don't really mean anything so long as they drift more or less together, at least to a first approximation. 

But if prices just have to change, most people would favor their increasing from excessive money creation rather than risk their falling under a stable money supply.  You can't shake The Premise.

I could go on and on, showing logically and empirically that the arguments don't hold, that the deflation bogey has no power, that hoarding won't destroy the economy, addressing every utterable concern anyone might think to raise.

But nobody is going to swallow it.  The Premise has hold of them.  These arguments can all be recognized as all true, but it has no impact other than discomfort and frustration.  It isn't convincing.  There must be some logical mistake, some contradiction, in these examples somewhere, shouldn't there?  But there isn't. 

Recognizing that this is so doesn't help.  Almost nobody is convinced.  That is because facts and empiricism have little power over premises. 

So, instead, I will here do my best to destroy The Premise. 

The Constant-Pricing Premise

I'm going to guess that almost everyone who clings to The Premise has in your mind a very simple and seemingly self-evident proposition -- money must be proportional to goods for "things to remain stable."  One might imagine the economy as a pile of goods, and the population as a pile of people, and the money supply as a pile of money, and they all need to be related, so that money "represents" the goods being traded among the people, and needs to remain within some window of proportionality or else things start to skew.

If that is not the exact line of reasoning, it is probably something close to it.  "That's the way we've always done it," even though it actually isn't. But it probably does hold true at least over the course of  the lifetime of anyone still alive today.

This is actually not an unreasonable thought.  It is a good place to start.  Prices are all about "money chasing goods," right?  If one increases, the other must increase proportionally to maintain order and stability.

But let me challenge this 'model' with a few questions.

The first question --

Which Goods? 

The marketplace is a pile of goods, sort of, but the case is not as simple as some undifferentiated mass of stuff.  Take my television for example.  It is an old piece of junk.  Nobody would go out and pay money for my TV.  Nevertheless, if anyone were to offer me money for it, I would only part with it for an unreasonably high price.  This is because I have so many old gadgets and adapters hooked into it to keep it working that it would be a real pain and an expense to me to get a new TV and set it up so that it worked properly.  Its replacement cost to me is much higher than its actual market value, which is probably close to zero if not actually negative.

On the other hand, if I were to decide I wanted to go to the expense of getting a new TV (not likely), I would probably simply throw the old one away rather than take the time to try to sell it.  The price I would get likely wouldn't be worth the trouble.  So the thing which couldn't be bought in one instance isn't worth selling in the other.

The point I'm trying to make is that many 'goods' are like my TV.  They're not really in 'the market' in that they aren't exactly 'for sale.'  Likely, the reader realizes that most 'goods' in existence are like this.  He probably isn't interested in selling his house, or his car, or his pets or clothes right this instant.  Not his spouse or children either, though some might make an exception. 

With those last examples one notices that a great number of 'goods' and 'transactions' don't even belong under monetary consideration, at least if you're a fairly decent person and enjoying more-or-less domestic tranquility at the moment, though they are still very much economic in nature.  Should these various non-market goods be 'represented' in the money supply, if money can't really 'chase' them at all? After all, if one were to include them they would likely swamp out the marketable goods entirely and he would wind up effectively with the fixed Austrian money supply.

That can't be right...

That simple mental image must be modified.  The pile of goods must be subdivided, with some goods 'in the market' and some tied up and sitting on the sidelines.  Maybe one could imagine this as something like GDP, the value of all goods and services bought in one year, vs. something like total accumulated wealth. The first would be roughly $14 trillion, the second somewhere on the order of hundreds of trillions of dollars.  Which is to say -- there's a big difference. 

But hold on.  That accumulated wealth can and does come on the market as capital is bought and sold and vice versa, such as when goods move from the marketplace and into my wife's closet permanently.  So we also have a dynamic situation here.  And GDP only includes all the goods sold.  It does not include unsold goods. What to do with those? How should we divide all this out?

Our simple picture is getting more and more complex, and we haven't yet looked at the second question...

Which Money?

Like the situation with goods, money is not homogeneous.  Yes, it all spends the same, but monetary statistics include different aggregates for a reason.  They don't all behave the same way. 

For example, you and I will never encounter the monetary base, which today stands at about $2 trillion and forms the credit basis which the banking system uses to create the larger aggregates.  M1 is, roughly speaking, the sum of all checking accounts, while M2 is, roughly speaking, the sum of all checking and savings.  You might think there's not much of a distinction to be made here, but the difference is substantial -- roughly $2 trillion for M1 and about $9 trillion for M2, and the two behave very differently. People think about their money  piles differently, and may set some back permanently as savings.  Surely this money won't be chasing goods and shouldn't be counted if one is attempting stable prices, but does this correspond to M2 less M1, or else how is it to be determined?  Further, M2 is rapidly convertible to M1 simply by moving money from one account to another. The piles are again all interrelated and dynamic.

Like our "pile of goods," we now have at least three very different and dynamic piles of money to deal with.  These aren't just simplistic undifferentiated masses.  They are complex and dynamic, and not under the control of any guiding entity.  Their movements and changes are spontaneous.

The Monetarist's Dilemma

There are three basic challenges the monetarist faces --
  • How does one differentiate and quantify the piles?
  • Which piles, if any, are the correct piles for comparison and adjustment?
  • How is money to be introduced or removed without distorting the market?

Which piles are the right piles?  What if economic circumstances change rapidly?  How's a central banker to measure and keep track of all this, let alone make any meaningful adjustments?  And if one is to think of 'money chasing goods,' does no description of the intensity of the chase come into the picture?  What if goods and money are just sitting there staring at eachother?  Is there no accounting for supply and demand of money itself?  Does it even exist? 

The situation is enough to make anyone's head spin, and rightly so.  It's tough playing Economic God.  This is why Milton Friedman, monetarist extraordinaire and a brilliant and passionate monetary theorist, had such a difficult time articulating exactly what the monetarist policy should be.  He thought the money supply should increase at a certain rate per year, but as to what the exact rate should be, he never could say.  And he wasn't even trying to keep prices stable!  As for "which money" supply should increase, well, that's a controversy in and of itself.  It's funny that economists are so convinced to the need to adjust the money supply properly when they can't even agree on exactly what money is.

Death of The Premise

The reader probably can't sort these things, out either.  I doubt anyone could.  But that's not the point, because nobody really needs to sort them out.  The point is that the picture one probably has in his head, The Premise, is innacurate and doesn't even begin to describe the real situation.  One isn't part of an orderly growing pile of people next to an orderly growing pile of goods and an orderly growing pile of money to 'represent' it all so that everyone can make 'orderly' transactions.  Besides, the sheer discrepancies of quantities in money and goods should have made it clear that money doesn't 'represent' goods in this way anyway.  The same money is used over and over to 'represent' many goods.  But everyone knows that -- it's fairly obvious.  Yet somehow most people still insist on proportionality.

The truth is, every economic actor is in the midst of a complex and disorderly system with blurry, ill-defined divisions, full of subjectivity and human passions that is more or less impossible to analyze and is completely outside of human control.  It's a little scary when viewed this way.  A money system couldn't hope to represent the real picture if this were the way money actually worked, and it is pure vanity to think it could be directed to do so by a human being.

But as I said, the good thing is that it doesn't have to.  This picture of the way money works isn't very accurate.

Next time, I'll continue on with a better "picture."

To be continued...

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