Does a money supply increase always result in misallocation?

Economics Economics Questions
1

I ask you all to forgive me in advance if this question seems too simple or trivial, but as I have, perhaps out of my lack of experience, been unable to reach a conclusion hitherto, I feel obligated to ask.

If I understand the Austrian theory correctly (and I am willing to accept that I don’t), an increase in the money supply, and the resulting dislocation of prices results in misallocation of resources. To this point I would definitely agree. We have seen enough of the ravages of inflation over the past decades to tell us that from experience. But what if (and I don’t suppose there would be any government entity that would have the self-control to do so, but it remains a possibility), what if the increase in the money supply was exactly in proportion to the increase in production? Assuming there is no change in the velocity of money, prices would stay the same. Or in a deflationary environment, what if the money supply was increased to offset the decline in velocity? Again, there would be no change in the price level. But would this cause misallocation, even if there was no increase in prices?

The logic I have seen used, involving the effects of inflation as it moves farther and farther from its source, would seem to indicate so. It would redirect capital from where it otherwise would have gone into the industries that benefit from the increase in the money supply, even if said sectors are not the most profitable in real terms.

But if this is true (and again, please correct me if it isn’t), then any increase in the money supply causes misallocation, which implies, that in a deflationary environment prices should simply be allowed to fall. Wouldn’t this end, however, with people hoarding their cash, and perpetuating the deflationary spiral, as it becomes more efficient (given the risk) to hold cash than to invest or spend? Moreover, isn’t this (that is, allowing the money supply to fall) exactly what helped drive us into the Great Depression?

I hope there aren’t too many questions here, but I am really curious to hear some clarifications from the Austrian crowd themselves, rather than resort to trying to infer from scattered bits and pieces which I have read. Thanks to you all for your time.

-Landon

2

“what if the increase in the money supply was exactly in proportion to the increase in production? Assuming there is no change in the velocity of money, prices would stay the same.”

You are making lots of far-fetched assumptions. First, you assume the new money is injected throughout the economy proportionally to existing dollar holdings, and not given to selected market participants like AIG first. Secondly, you assume the production of different goods and services would change in lockstep with consumer demand. In reality, if there is 2x as much money and 2x as many cars produced, I would spend my new money on entertainment or store it in the mattress, say, rather than buy a second card. Thirdly, you assume prices and wages - and contractual agreements - would magically adjust overnight in response to the money supply change.

“deflationary environment prices should simply be allowed to fall. Wouldn’t this end, however, with people hoarding their cash”

People cannot simply hoard their money, as they do need to eat. Computer prices constantly “deflate”, yet we still see people continue to purchase PC’s instead of waiting forever for the “perfect” PC.

“in a deflationary environment prices should simply be allowed to fall.”

In Austrian economics, deflation is defined as a decrease in the money supply, which does tend to make prices fall. Before the Fed was established, there were decades of gradually decreasing prices in USA due to increasing productivity. This is great for consumers and proof that the free market working. It’s not clear why would you want this process to be dis-allowed through government-sanctioned counterfeiting.

3

Analyzing it at the price level is just one perspective on the same event. The dislocation in prices reflect a reallocation of resources and wealth, via the creation of money.

The price Austrians specifically focus in relation to business cycles is the interest rate, which is far removed from the price level that you are mentioning(the price level that the Fed targets). All Austrians would argue that there is no benefit to targeting the price level, although a minority would prefer to target nominal spending.

There’s a couple other big parts of the picture that are being left out. For instance, money creation increases the supply of cash balances while the demand to hold cash balances does not change. This lowers the demand for money, increasing money velocity as this demand is displaced into real goods. The change in demand for money promotes a new increase in spending levels throughout the economy. These new spending habits direct production toward certain services that are simply not sustainable at a lower spending level(see Coldstone Creamery).

Another perspective on the increase in cash balances(having the same effect) is that money creation appears to increase savings in the economy, but it is illusory. So these savings are consumed in the present, when consumption otherwise would have been deferred until savings naturally increased to these levels in the future. So all money creation does is shift consumption from the future, to the present. This change in consumption readjusts the structure of production in the economy. But since this consumption is displaced from the future, at some point in the future, consumption has to decrease. This decrease in consumption again changes the structure of production(although in a painful way this time).

While this can exacerbate drops in spending, it can only do so for so long. Don’t forget, all things being equal, people prefer to have goods now, rather than in the future. There will always comes a point where the marginal benefit of a reduction in price equals the marginal cost of foregoing the desired good. Human history has never seen an economy implode in on itself in this manner before… and I would argue it never will. If the spiral never stopped, eventually people would be starving to death while holding on to cash, because the price of bread may go down another penny.

The Great Depression was already coming in full force before the collapse in money stock. Aggregate working hours plummeted well before any significant drops in base money. I wish I had a source on that, but I completely forgot where I came across that graph.

4

Thank you very much for replying. Both responses have been thought-provoking.

I think, however, that there is a fundamental flaw in the arguments here for deflation, and against targeting the price level. That is, you assume that deflation does not cause resource misallocation (or at the least reallocation) as well as money creation. If, as in baxter’s example, the drop in price is a result of real increase in productivity, etc., then obviously there would be no such misallocation, but if, as in the example of the Great Depression, there is a shock, and a sudden shift in the demand for money, or the velocity of money, which causes prices to drop, there is a transfer of purchasing power to the end consumers, just as there is a transfer of purchasing power from end consumers in instances of inflation. If this benefits these consumers, it does so only at the expense of an equal decline in purchasing power elsewhere in the economy. Your example involving bread prices only demonstrates that I will not completely cut off consumption during a deflationary period; it says that there is a floor to such deflation. But this does not mean that the process of deflation (and to be fair, you concede as much), does not have a tendency to exacerbate and prolong a recession. Now, to be clear, when speaking of the Great Depression, I did not claim that the contraction of the money supply was the original cause; that is a question which is complex and multifaceted, and beyond the scope of this discussion. What I did say was that allowing the money supply to fall after the fact certainly contributed to making the depression worse than it otherwise would have been. You seem to admit the possibility yourself when you say that, “[money hoarding due to deflation] can exacerbate drops in spending.”

-Landon

5

The increase in the money supply is the cause for the misallocation, which leads to the unavoidable bust. So claiming that an increase of money supply is desirable once the bust occurs, is nonsensical! it is only those who do not understand the causes of the boom/bust cycle who can possible make such a ridiculous claim.

So what? If this is the result of voluntary choice by free market actors, what possible alternative do you suggest? socialism?

6

“It is only those who do not understand the causes of the boom/bust cycle who can possible make such a ridiculous claim.”

Would Hayek qualify as someone who understands, “the causes of the boom/bust cycle”?

“I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.”

-Landon

7

Under what, if any, conditions can an expanding money supply not create a misallocation of resources?

8

Any expansion of the money supply needs to create some distortion. This is because whatever the new money is spent on first will rise in price before other products are bought with that money. That said, small expansions of the money supply that are not done through the banking system should have a neglible effect on the economy.

9

A change in relative prices isn’t necessarily a distortion. If the rate of saving increases, then spending will shift from consumption goods to capital goods. If monetary expansion rises the price of capital goods, but is matched by a falling price of consumption goods, then is there a distortion?

10

Yes, because the price of capital goods would rise more than they otherwise would have.

You’re also falling into error by thinking in the aggregates of “consumption” and “saving.” Newly printed money doesn’t simply increase “consumption” or “saving,” it does much more than that. That newly printed money is spent on specific products. If new money is spent on financial assets or if the new money is injected through the banking system, then obviously the capital structure will be distorted since more money will be spent on capital goods than otherwise would have. BUT, even if the newly printed money is consumed, it would be spent on certain products in the consumer economy. Who knows what it could be spent on, but it could be spent on numerous items. The price of these items would rise abnormally at first in relation to other prices, and then fall. There would be no doubt however, that some kind of distortion occurred. That said, a rise in consumption wouldn’t really change investment patterns, thus preventing capital misallocation, and a small increase in the money supply would barely distort to begin with.

11

But by that definition, all spending is distortionary, since prices would always rise more than they otherwise would, i.e. more than without the spending. In any case, suppose the money supply expands, spending on capital goods increases (rising prices and encouraging supply), and meanwhile spending on consumption good declines (reducing prices and discouraging supply). Further, suppose that spending on capital goods increases in exact proportion to the decline in consumption goods spending. How would you explain that?

12

Not necessarily. Spending done with already existing money is directed towards products for which there has been a past demand and there most likely will be a future demand. Spending done with newly printed money only temporarily pushes up the demand for a specific product or group of products. Herein lays the difference.

13

Does it matter? Any injection of new money necessarily increases demand for the products that money is spent on. This increase in demand (and thus profits) is temporary and unsustainable.

14

Thank you all for your replies, especially krazy kaju. I suppose, then, that the answer is yes, it does, but it is a question of degree. Also, it is not entirely clear that such disturbances are not, in extraordinary cases, justified. The economic havoc that resulted from allowing the currency to rapidly depreciate during the Depression would, I think, be an example. This also seems to put a hole in the Austrian insistence on a rigid gold standard. I can envision a free-market money supply system, such as I have heard some advocate; I cannot envision a system wherein humanity is bound to the quantity of specific precious metal for no other reason than the temporary, and often minor, disturbances occasioned by any increase in the money supply. Of course, all this is not to say that a central bank should have the power to arbitrarily do so; when it does it can wreak its own havoc. It is only to say that there is a greater case for price stability than, perhaps, is allowed.

-Landon

15

I suggest you read more of Hayek then one quote popularized by the Internet!

A deflationary policy according to Hayek, would be for the Fed to engage in money supply contraction as opposed to money supply expansion.

Letting the money supply contract naturally as the inevitable consequences of the previous expansion would not be considered deflationary policy, according to Hayek, but simply avoiding the continuation of the inflationary policy that had caused the boom.

According to Hayek, any increase in the money supply, causes a distortion of the interest rate, so any increase in money supply, no matter how little, would be counterproductive!

16

IIRC, both Mises and Hayek, probably the Austrian school’s two most public intellectuals, supported some form of money expansion. Both recognized that the money supply should be in private hands, and not in government hands, and both recognized that a completely rigid money supply was a pipe dream. I believe that their main critique was how the money supply was expanded by the central banks, which created much more severe distortions to the economy than other methods of monetary expansion.

Of course, all deflation isn’t bad. There is growth-induced deflation, which occurs when the economy grows quicker than the money supply. That said, a free market, stable-value currency as described by Hayek is probably more desirable than a deflationary currency.

17

It would still tamper with businesses’ calculation of profits or losses.Maintaining the stability of the general price level doesn’t mean that there wouldn’t be a bust to hit us, simply because credit that is expanded to offset the price level drop will tamper with the natural market interest rate. So businesses which calculate business returns based on this artificial interest rate, will invariably be lead to make mal-investments, that is, investments which seem profitable at the artificially tampered lower interest rate but won’t remain the same once savers re-establish their real rate of time preference, that is, once the natural interest rate is re-established.

Getting real, there is no reliable technique or tool which can tell governments exactly how much inflation is required to maintain the price level.

You again tamper with the interest rates, sending the wrong economic signals to businesses.

This is actually no problem to be associated with business cycles. The ABCT is basically a theory of credit induced trade cycles. Giving new money to some people and letting them spend and re-allocate resources according to their demands does not cause problems. It just redistributes the way resources are used.

Last, I think you should re-look your understanding of the business cycle theory. The problem is not exactly with the price level. It’s rather with tampered interest rate.