Former Austrian economist George Selgin has a new article out on his blog critiquing The Mises Institute’s Robert Murphy on a post he made about the faults of Market Monetarism. In the grand scheme of things, I find myself at odds with both, yet in agreeance as well. Simply put, I mostly agree with the theoretical underpinnings of market monetarist; NGDP targeting. I think it provides the best current-day solution to preventing monetary disequilibrium, which every economist should agree is a worthwhile goal.

However, that’s where my truce with the market monetarists ends and my alliance with the Austrians remains strong; a real-world solution. I think a free banking system with competitive note-issuance can do this better than one with a central bank steering monetary policy. With that being said, I want to make a few brief comments on Selgin’s points in his article:

Still, there are exceptions; and Murphy is one of them.[1] He writes as if it were still 1960, and as if the pace of money growth alone could be treated, as old-fashioned Monetarists once treated it, as a sufficient indicator of the tightness or looseness of monetary policy. Remarkably, the word “velocity” never even comes up in his essay.

The Austrians constantly rail against the out-dated arguments of the old monetarists as if it’s still a relevant topic in terms of policy today. There is almost no one making the old Friedman-esque case for a stable increase in the money supply. In fact, the Austrians like Murphy, Jesus Huerta de Soto, and Joe Salerno are a little imprecise on this. On the one hand, they criticize Friedman and the monetarists for not recognizing that the velocity of money (roughly the inverse of the demand for money) was unstable. Yet, on the other hand, they often claim the velocity (and thus the demand for money) has no reason to change much that would warrant any increase or decrease in the money supply to offset it. Here is de Soto:

Curiously, like Keynesians and monetarists, modern free-banking

theorists are obsessed with supposed, sudden, unilateral changes in the

demand for money. They fail to see that such changes tend to be endogenous and to occur throughout an economic cycle which is first triggered

by shifts in the supply of new money the banking system creates in the

form of loans. The only other situations capable of producing a sudden rise in the demand for money are exceptional, like wars and natural disasters.

These Austrians have created a problem for themselves. If Friedman was wrong that a stable increase in the money supply did not keep pace with velocity, sometimes falling short and other times exceeding it, then this change in velocity relative to the change in the money supply must have been unexpected and sudden enough to cause macroeconomic problems like the boom-bust cycle. Yet, as de Soto’s quote explains, they have no reason to expect a sudden decrease in velocity in a free market.

Why is the instability of money velocity a problem for a policy of stable increases in the money stock, but that instability will magically disappear when 100% reserve banking is implemented? Selgin points out later in the article that Murphy’s analogy assumes “constant velocity.” Well, which is it?

Murphy’s claim makes sense only assuming that the velocity of money didn’t decelerate enough to offset, or more than offset, the more rapid money growth he documents.

This is usually a problem with many Austrians. They assume any increase in the supply of money is “easy money”, but don’t recognize the importance of money velocity and thus savings and interest rates. If velocity falls in accordance with higher savings rates, the natural rate of interest should fall. Market rates of interest should fall as well, increasing credit expansion. Whether the Fed should do this or not is beside the point for this specific argument when Austrians overlook the importance of money velocity when speaking about reductions in it.

Monetarists, “Market” ones included, tend to downplay the importance of Austrian-style boom-bust cycles, while some Austrians dismiss the Monetarist theory that busts are caused by money shortages. This is a shame, because it often takes both theories, and then some, to explain any actual cycle. I’m pretty sure that’s so for both the 1927-33 and the 2005-10 cycles. In each of these episodes, a period of overly-loose money was followed by one in which money was too tight, adding the insult of deflation to the injury of malinvestment.

I agree with Selgin here, but he should put it more succinctly; Austrian business cycle theory and the monetarist concern with a shortage of money are two sides of monetary disequilibrium, the former being the inflationary version and the latter being deflationary. An excess supply of money (relative to the demand to hold it) will create a boom and a bust, and an excess demand for money (relative to the supply of it) will create a bust. The severity of either version of monetary disequilibrium will depend on the degree to which the supply of and demand for money are not coordinated.

There is, by the way, nothing particularly un-Austrian about the arguments I’ve just made. Similar ones can be found in Hayek’s writings of the mid-1930s, and especially in his 1933 essay on “Saving,” reprinted as chapter five of Profits, Interest and Investment. They occur as well in chapter twelve of Fritz Machlup’s 1940 work, The Stock Market, Credit, and Capital Formation. The same ideas take up a large chunk of chapter four of The Theory of Free Banking, which I wrote while I was still a very Austrian grad student, and a similarly large chunk of Steve Horwitz’s Microfoundations of Macroeconomics. The case of von Mises is more complicated. While certain passages of his appear to treat any growth in the quantity of “fiduciary” money as harmful, others suggest on the contrary that such growth can help to keep relative prices where they belong. Thus he observes, in The Theory of Money and Credit, that insofar as banks “increase and decrease their circulation pari passu with the variations in the demand for money… they make an essential contribution to stabilizing the inner objective exchange value of money.” As Jörg Guido Hülsmann explains, Mises regards “a stable inner objective exchange value of money” as a monetary policy ideal, albeit one that’s unobtainable in practice.

I disagree with Selgin, Murphy, and the Austrians here. I don’t think we should pay too much attention to what Mises, Hayek, etc thought about banking, money, or booms. They often made statements that somewhat contradict former claims they made, or at least cast doubt on what they really meant. Evidence is shown here, here, and here. Notice that some of these posts date back a decade ago. These debates will go on for a long time unfortunately.

Let me be clear and say that what these Austrian economists thought is important because it has shaped the views of Austrians today, but arguing about what Hayek really meant in chapter 2 of Prices and Production has a high opportunity cost; time. Economists like Robert Murphy and George Selgin could be using their time more wisely (like in this article) by figuring out important answers to problems like what the optimal monetary system is.

In fact, Murray Rothbard and those who cleave to his teachings, including Murphy, are the only Austrians—if not the only economists of any school—who deny that monetary expansion can be beneficial even when it matches corresponding growth in the demand for real money balances. Their dissidence has several roots, one of which is their belief that, instead of being rigid or “sticky,” prices are perfectly capable of quickly adjusting downward in response to such shortages. If prices respond quickly enough, people can always have all the real money balances they want, without delay, even if the money stock never grows.

Both Murphy and Rothbard have exposed themselves as being ambiguous on the issue of sticky wages as I point out here, as well as in my book Monetary Kaleidics. I don’t find a reason to take them seriously on this issue anymore until they, or in the case of Rothbard, his followers respond.

In sum, although I find Murphy to be a good economist, and a devout Austrian at that, I think he often exposes himself on certain monetary matters when debating with men like George Selgin. It’s moments like these that make it clear that the “old Austrian theory of money” should go the way of old monetarism.