Category Archives: Stimulus

On Fiscal Policy

In recent weeks, there seems to have been a resurgence in the discussion of the relative effectiveness of counter-cyclical fiscal policy. This discussion is clouded by the fact that there are some whose political ideology seems to get in the way of reasonable discussion of evidence (and who believe that only those who disagree with them are biased!). In this post I would like to make the following points: (1) there is no such thing as “the” fiscal multiplier, (2) empirical and theoretical estimates are highly sensitive to assumptions about monetary policy — assumptions that seem to be violated by the behavior of central banks, and (3) New Keynesian models are flawed models for estimating a fiscal multiplier (especially in the context of log-linearized equations).

The most fundamental point surrounding the discussion of the fiscal multiplier is that there is, in fact, no such thing as “the” fiscal multiplier. Put differently, the fiscal multiplier is not a structural parameter that can be identified through careful theoretical or empirical work. To the extent that it is possible for a fiscal multiplier to exist, such a multiplier is likely to be dependent on a number of other factors such as the monetary regime and the composition of spending, to name two.

This point is important as it pertains to interpretations of empirical work designed to measure the magnitude of response of a change in fiscal policy. For example, in order to empirically estimate the magnitude of the effect of fiscal policy on output, one needs to find some sort of exogenous change in government purchases to avoid problems of endogeneity in estimation. To avoid the problem of endogeneity, many researchers have used military purchases since military build-ups in the face of war can be considered exogenous (i.e. the government isn’t building tanks to increase GDP, but to fight a war). These types of studies provide estimates of a multiplier effect of military purchases on real output. However, it is important to note that these estimates do not necessarily provide an estimate of a fiscal multiplier that corresponds with all forms of government spending. The composition of spending matters.

This point is particularly important when we consider the differences between the these estimates and the likely effects of the American Recovery and Reinvestment Act (ARRA), or as it is commonly referred as “the stimulus package.” The ARRA is not made up of a significant chunk of military spending. In fact, a significant portion of the ARRA consists of transfer payments. Even in the Keynesian income-expenditure model that is unfortunately still taught to undergraduates to understand macroeconomics, transfer payments have no effect on GDP. Thus, the multiplier effect of these provisions is zero. It follows that it would be incorrect to take an estimate of a fiscal multiplier from studies that use military spending as an explanatory variable and apply that multiplier to the total amount of spending. In addition, there is no obvious reason to apply this multiplier to the non-transfer payment fraction of the ARRA as it is not obvious that the marginal impact on real output from building a road, a bridge, or a school or buying a new fleet of government vehicles is equal to the marginal impact of military spending.

Even if we ignore the issue of the composition of spending on estimates of the multiplier, it is necessary to consider the effects of fiscal policy in light of monetary policy. If monetary policy responds actively to changes in economic conditions, then a purportedly effective fiscal policy will cause monetary policy to be more contractionary that it would have been otherwise. Put differently, monetary policy will offset, either in whole or in part, the effects of fiscal policy.

Recent theoretical and empirical work seems to appreciate this point, but argues that at the zero lower bound on nominal interest rates, monetary policy is ineffective and therefore fiscal policy can be effective. But how valid is this assumption? Central bankers certainly don’t believe that monetary policy is ineffective at the zero lower bound. If so, there would be no debate about quantitative easing because none would have taken place. In addition, this assumption requires that monetary policy work solely through the nominal interest rate (or the expected time path of the nominal interest rate). However, if this is the case, then monetary policy is always relatively ineffective because interest rates do not have strong marginal effects on variables like investment. Empirical work on monetary policy over the last 20 years seems to refute that ineffectiveness proposition. In fact, Ben Bernanke’s work on the credit channel is motivated by the very fact that the federal funds rate seems insufficient to understand transmission of monetary policy. Once we dispense with this notion of the ineffectiveness of monetary policy at the zero lower bound, we realize that empirical studies that estimate a fiscal multiplier by holding monetary policy constant are really estimating a strict upper bound.

These empirical estimates, however, have been informed by the predominant framework for monetary policy and business cycle analysis, the New Keynesian model. In the NK model, monetary policy works solely through changes in the interest rate. As a result, at the zero lower bound, fiscal policy can be effective — quite effective in some cases. Nonetheless, there are reasons to doubt these estimates of the fiscal multiplier. First, if monetary policy works through alternative transmission mechanisms, then the assumption that we can hold monetary policy constant is flawed. Second, even if we believe that the zero lower bound is a legitimate constraint on policy there is reason to believe that the estimated marginal effect of fiscal policy in the NK model is flawed.

The most compelling reason to doubt the multipliers that come from NK models, even imposing the constraint of the zero lower bound, is that these estimates are driven by the particular way in which these models are solved. For example, Gauti Eggertsson (and others) have pointed out that in the NK model at the zero lower bound, there is something called the paradox of toil. Intuitively, the paradox of toil refers to the characteristic in which the labor supply actually declines following a decrease in taxes. A paradox indeed! (Upon hearing this a commenter who shall remain nameless at a recent conference at the St. Louis Fed found it interesting that presumably it would be possible to increase government spending and fund the increase through higher taxes on labor income all while generating a multiplier effect.) This characteristic is part of a broader conceptualization of the world at the zero lower bound. In short, things look profoundly different than when the interest rate is positive.

But is the world really that different at the zero lower bound? The answer turns out to be no. As Tony Braun and his co-authors have shown, the funny business that goes on at the zero lower bound (i.e. the conclusions that run counter to the conventional wisdom in the discipline) is a figment of the way in which NK models are solved. In particular, the standard way to solve models in the literature is to take a set of non-linear equations that summarize equilibrium and log-linearize around the steady state. One can then generate theoretical impulse response functions from the log-linearized solution to the model. The impact multiplier from the change in government spending in the NK model is therefore a theoretical estimate of the fiscal multiplier. However, it turns out that when the models are solved through non-linear methods the counter-intuitive results disappear and the theoretical estimates of the multiplier are substantially lower — again, even imposing the zero lower bound as a constraint.

The general takeaway from all of this is that there is reason to be skeptical about the discussions and the purported precision of estimates of the fiscal multiplier — whether theoretical or empirical. (And that is to say nothing about the political constraints that go into devising the composition and allocation of spending!) However, what I have written does NOT necessarily imply that there is no role for fiscal policy during a recession. If some form of infrastructure investment by the government passes the cost-benefit test, I think that it is certainly reasonable to move such projects closer to the present because even in the absence of a multiplier effect these projects provide something of value to society. If there is an additional effect on output, then all the better.

Economics and Politics

I repeatedly hear claims that solving the current global economic problems merely requires political will. If it wasn’t for the Republican obstructionists or the pigheaded Germans, the problems could (would?) be solved. What I find frustrating about this narrative is its simultaneous simplicity and certainty about the necessary policy prescriptions. Isn’t it possible that so-called Republican obstructionism is the result of a belief on the part of Republicans that the policies they are supposedly obstructing would be ineffective or deleterious? Isn’t it possible that the German leadership is opposed to many suggested policy prescriptions because they believe that many of these proposals simply kick the can down the road and leave them holding the bag? (Isn’t it possible to squeeze countless metaphors into one sentence?!)

The point that I am making is not that the Republicans or the Germans are correct, but rather that it is not certain that they are incorrect. And in the case of Germany, it would seem that they have little to gain and much to lose by helping troubled Eurozone members. Many forget that from the German perspective the ECB’s monetary policy is close to optimal. As such, Germany is likely to be the most insulated from a European economic slowdown — at least according to New Keynesian-style logic. If it makes economic sense for the German leadership to take the position that it does, how can we fault them? Perhaps one could argue that they should care about their fellow Europeans, but that is philosophical and something that is beyond the scope of economics.

In the U.S., what types of policies have been prevented by political obstructionism that would have helped? What evidence is there that these policies would have helped? Is there a competing narrative that can explain the same outcome?

Frequent readers know that I think that monetary policy in the U.S. has been suboptimal. There are “political will” narratives here as well. Those who think that monetary policy has been tight think that the Fed lacks the political will to do what is correct right now. Many of those who think that monetary policy is going to create higher rates of inflation in the near future think that the Fed will lack the political will to bring down inflation when it starts to rise.

A much simpler story is that the Fed is an inflation targeter, with a not-so-implicit-anymore target of 2%. Under this narrative, the past rate of inflation is irrelevant. What matters is preventing the inflation rate from being consistently below target. When I look at the data and when I read speeches by folks like Jim Bullard, this seems entirely more plausible than the political will narrative.

In addition, if the political will narrative is correct, then aren’t these arguments really arguments against the Federal Reserve itself rather than merely policy? In other words, if there is an optimal policy that the Federal Reserve refuses to pursue because of political risks such as diminished credibility, then why have a monetary authority in the first place?

The political will narrative is easy to adopt and probably has some psychological appeal as well. If the POTUS isn’t signing into law policies that you believe would help or if the central bank isn’t following the policy that you believe would be optimal, it is perhaps easiest to think that they simply lack the political will to get things done. Whether policy has been optimal also depends on the objective. If the Fed’s objective is 2% inflation, then they have done a remarkable job. If the Fed’s objective is a trend path for the price level or nominal GDP, then they have done a substantially less than remarkable job. Perhaps it is political will that explains the policy path that has been chosen, but it is possible that there are alternative and entirely valid explanations of such a path.

The Strangest Thing I Read Today

Via Scott Sumner, I find Ezra Klein considering counterfactuals about policy and the recession. However, two sentences stuck out as particularly odd:

The stimulus was a bet that we could get out of this recession through the one path everyone can agree on: growth. The bet was pretty much all-in, and it failed.

The stimulus was about growth? Not the stimulus package that I saw.

The stimulus package was a “gap-closing” policy and the emphasis seemed to be more toward preventing the loss of public sector jobs like teachers, police, and fire service — as evident by the substantial chunk of the package that was devoted to transfers to states. Now we can debate the merits of such policies until we are blue in the fact, but there was very little in the way of growth-producing policies consistent with economic theory (and that remains true if you think that the transfer payments were good policy). What precisely was pro-growth about the stimulus package? Perhaps I missed something.

Expectations and Policy

I wrote in my previous post that expectations matter. This is something that cannot go understated and is often disregarded when talking about the effects of policy. For example, David Wessel writes:

In our time, says Mr. Ahamed, “I don’t think Keynesians or even monetarists ever realized that the numbers to make their policies work are so gigantic. Everyone had sticker shock.” The Obama stimulus seemed huge and the Fed’s quantitative easing—printing money to buy bonds—looked massive, but in retrospect perhaps they weren’t sufficiently large.

I continue to hear that the problem with fiscal and monetary stimulus in recent years has been one of magnitude. Monetary and fiscal policy have failed because they simply were not large enough. This is the argument prominent in the quote above. When I hear this, however, I cannot help but to think that we have failed to learn the lesson of the Lucas Critique.

I am fond of using the equation of exchange to communicate points about monetary disequilibrium. The modified equation of exchange that David Beckworth and I often use is:

mBV = PY

where m is the money multiplier, B is the monetary base, V is velocity, and PY is nominal income. This is essentially a reduced form equation that captures the determination of nominal income. Personally, I find this as a useful guide for explaining what happens when there are deviations of desired from actual balances. It is, of course, possible to explain this within other models (both simple and complex), but this seems to be a useful device for organizing one’s thinking on the topic and especially for communicating the concept through blogging.

With that being said, I do not under any circumstances see the equation of exchange as representing a menu of policy options. Why? Because expectations matter.

The (simplified version of the) lesson of the Lucas Critique for econometric policy evaluation is that we cannot simply plug in the size of a policy to some “structural” model of the economy and expect it to tells us the size of the effect of the policy. The reason is because when policy changes, this can effect expectations and therefore the marginal effect of a policy. In other words expectations matter.

One way to think about this is in terms of my original critique of the fiscal stimulus package. In that post I outlined the importance of Ricardian equivalence — the idea that government debt is not net wealth. (While there are many reasons to doubt that Ricardian equivalence holds, it does seem to be a close approximation to reality based upon empirical evidence.) To understand this concept, consider a simple scenario. Suppose that the only way to save is by purchasing government-issued bonds. Now consider the effects of a temporary tax rebate financed through deficit spending. In this scenario, the government issues a bond in the amount of the rebate and promises to pay the buyer back with interest. The government then uses the proceeds of the sale to give a tax rebate. If the individual receiving the tax rebate (correctly) perceives that they will have to pay back the amount of the tax rebate plus interest in the future, they would simply use the proceeds of the tax rebate to purchase the bond. In other words, there is no effect. Government bonds are not net wealth.

The lesson from this example is that expectations matter. The tax rebate does not alter the individual’s tax liability. Thus, the individual uses the rebate to increase saving in order to pay future taxes. Similarly, a permanent increase in government spending increases an individual’s future tax liability thereby producing a similar result. The increase in government spending is thereby offset by a corresponding reduction in consumption. Thus, when one looks at the effects of such a policy in its aftermath, one could either conclude that the policy was ineffectual or that the policy simply wasn’t big enough.

This brings me back to the discussion of monetary policy. The equation of exchange, as articulated above, is an organizing relationship that helps to understand the concept of monetary disequilibrium. However, the same logic applies to the role of expectations for monetary policy. For example, suppose that we observe a sharp reduction in the money multiplier (an increase in the demand for base money) and a corresponding reduction in nominal income. If monetary equilibrium is the policy goal (which I am assuming it is), then monetary policy needs to adjust to promote stability in nominal income by increasing the monetary base. I DO NOT, HOWEVER, pretend to know the magnitude by which the monetary base should increase nor is there any model in existence that can tell us with any degree of accuracy by how much the base should increase. In addition, it is undoubtedly true that the answer is not that which exactly offsets the decline in m that was observed. Why? Because expectations matter.

Just like with the example of fiscal policy, we can draw important lessons for monetary policy. The question is whether monetary base injections are perceived as net wealth. If the Federal Reserve were, for example, to announce that they were going to temporarily increase the monetary base because of the decline in m, this has an impact on the expectations of individuals in the market. If any introduction of new base money is expected to be pulled back out of circulation after a short period of time, money (like bonds in the previous example) will not be seen as net wealth and will simply be held. In the aftermath of such a policy, one could either conclude that the magnitude of open market operations wasn’t large enough or that the policy was ineffectual.

This does not, however, mean that monetary policy is impotent. It means that expectations are important. In fact, monetary policy can be successful if it partners the monetary injection with an explicit account of expectations. If monetary policy was conducted by announcing that the central bank would increase the monetary base until it met its target for a particular variable — say the price level or nominal income — this would help to shape expectations and help policy to be successful as the increase in the monetary base would have distributional effects.

The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.

Ricardian Equivalence

There seems to be some confusion about Ricardian Equivalence floating around the blogosphere (see Nick Rowe’s attempt at mediation here). I’m a bit pressed for time, but in lieu of my own comments I would like to recommend a great survey by John Seater on Ricardian Equivalence that would seem useful for the present discussions about theoretical and empirical issues.

Thoughts on Fiscal Stimulus

I finally got around to listening to Russ Roberts’s podcast with Steve Fazzari about the stimulus package. While it was encouraging to hear a civilized conversation on the matter, I have come away with a pessimistic view about any likelihood of forging a consensus on the role of fiscal stimulus.

This pessimism is further enhanced by examining the evidence presented in the blogosphere. For example, Paul Krugman recently argued that fiscal stimulus wasn’t even tried:

What’s extraordinary about all this is that stimulus can’t have failed, because it never happened. Once you take state and local cutbacks into account, there was no surge of government spending.

Meanwhile, John Taylor presents a graph that shows:

…that state and local governments did not increase their purchases of goods and services—including infrastructure—even though they received large grants in aid from the federal government. Instead they used the grants largely to reduce the amount of their borrowing as the following graph dramatically shows.

Each of them are looking at similar data and coming to vastly different conclusions. The reason for the differing conclusions is the result of the identification problem. For example, it is possible that borrowing by states declined as a result of the fact that the federal government increased grants to states. However, it is also possible that the grants to the states offset planned reductions in borrowing. In the former case, the stimulus was ineffective. In the latter case, the grants possibly prevented a worse outcome. An abstract look at the data, however, is not sufficient to draw a conclusion.

It would be a mistake, however, to equate my pessimism about a consensus with pessimism about the process of evaluating the stimulus. I predicted in February of 2009 that the stimulus would fail and I believe that I have been proven correct.

Given the identification problems involved, how can I possibly think that I am correct? First, it is important (and necessary) to judge the stimulus by a particular criteria. I, for example, choose to judge the stimulus by the criteria outlined by Christina Romer and Jared Bernstein. The reason that I think the stimulus should be judged based on this criteria is because it is based on an explicit model, it produces specific predictions about the effects of the stimulus, and it represents the views of the policymakers who passed it. With the criteria chosen, it is then possible to evaluate the effects of the stimulus.

I don’t think that I need to go into much detail to suggest that the stimulus failed with the chosen criteria. Romer and Bernstein predicted that without the stimulus the unemployment rate would peak around 9% in 2010. However, with the stimulus the unemployment rate was projected to peak around 8% in the third quarter of 2009. Casual observation demonstrates that this projection was false. Based on this criteria, the stimulus failed.

Critics of this type of evaluation make two charges: (1) they argue that the economy was worse than expected and thus the effectiveness of the stimulus was less than expected as well; and (2) that things would have been worse without the stimulus.

Was the economy worse than realized? After the fact we might say so, but what is our evidence that the economy was actually worse than we thought at the time? It is true that Bernstein-Romer’s forecast of the peak unemployment rate with the stimulus was lower than the actual unemployment rate, but is that prima facie evidence that they under-forecast what unemployment would have been in the absence of the stimulus? No. The identification problem rears its ugly head again. It might be true that the model simply under-forecast unemployment. However, it also might be true that the stimulus was ineffective and the model’s predictions about the effectiveness of the stimulus were wrong. What’s worse is that in either case the model is significantly flawed and therefore not particularly useful for policy analysis.

Others claim that things would have been worse without the stimulus. Whether true or not, this point is irrelevant. There is no predictable content in that statement. In addition, the fact that things could have been worse is not in and of itself a strong justification for stimulus. It is important to understand how much worse it could have been. For example, would it have been worth it to spend $800 billion to reduce unemployment by 0.1%? By 0.5%? In other words, it is important to consider the fact that while there are potential benefits to stimulus, there are also costs — both monetary and non-monetary. The idea that it could have been worse says nothing about whether the benefits exceed the costs.

Prior to the recession, I thought that there was an emerging consensus on the role of fiscal stimulus (one fellow blogger even referred to my original post on the stimulus as a short lesson in Ph.D. macro). Perhaps there is largely a consensus within academia that seems smaller due to the voices that propagate the blogosphere and policy circles. Or perhaps that consensus is only imagined. Regardless, it is clear that influential minds still believe in the power of fiscal stimulus and are not persuaded by the evidence presented above. Nonetheless, the evaluation of fiscal stimulus cannot be made in the abstract. The only reasonable means to evaluate stimulus is to do so in light of ex ante predictions about the effects of stimulus derived from an explicit framework. Based on this criteria, the stimulus has failed.

Is David Beckworth Crazy?

Not to give away the conclusion, but the answer is ‘no’. Nonetheless, the title is provocative. (Perhaps, that is why Brad DeLong uses these types of headlines).

In all seriousness, I would like to address a recent criticism of David Beckworth. Those who have been reading the blog for the past couple of years will recognize that much of what has been written has been aimed at outlining a particular framework and addressing what that framework implies. At times, this has been done for the analysis of fiscal stimulus and at other times for monetary policy. Regardless, my goal in writing serious posts on this blog for the last couple of years has been in trying to engage readers in a serious discussion about particular topics. Specifically, I have tried to outline my preferred framework for analysis and challenge those who disagree to explain why. Unfortunately, this hasn’t been as successful as I had hoped. The lack of success is not because others have refuted particular ideas, but rather the fact that those who have engaged in the debate have often merely attacked straw man representations of the framework espoused herein — especially with regards to monetary policy.

Having said all of this, the subject of this post is something that was written by Robert Murphy regarding views espoused by David Beckworth regarding monetary policy and, in particular, quantitative easing.

Murphy begins by labeling Beckworth’s views as “monetarist Keynesianism.” I would call this an oxymoron, but it seems far beyond such a simple description. The term seems to refer to the use of “Keynesianism” by certain economists of the Austrian persuasion as synonymous with “interventionism”, but I digress. I would hope that we can dispense with labels as they are often, as this example illustrates, misused and distract from the substance of the conversation.

Now, on to the substance. David wrote an article for the National Review Online attempting to justify quantitative easing. Why does the economy need quantitative easing? David Beckworth explains in the article:

[QE2] is about fixing a spike in the demand for money that has significantly hampered spending.

He then goes on to detail the behavior of aggregate nominal spending in the U.S. economy and demonstrate how it has fell short of its long-run trend and that it can be explained by tight monetary policy (excess money demand). Robert Murphy then replies:

And there you have it, clear as a bell. Paul Krugman couldn’t have said it any better. According to Beckworth, the problem with our economy is that people aren’t spending enough.

This simple idea is very powerful; it permeates our financial press when they wring their hands and wonder if “the consumer” will buy enough Tinkertoys this holiday season “to pull the economy out of recession.” But of course, if spending were really the trick to having a growing economy, then the world would have eliminated poverty long ago. No, it’s production that is the real obstacle; consumption can take care of itself.

This critique sounds harmless enough, but it misses the point. David’s argument is not predicated on the belief that more and more nominal spending will generate prosperity and eliminate poverty. Rather, David’s point is that falling nominal spending reflects excess money demand and therefore implies that monetary policy is too tight. This view is based on the concept of monetary disequilibrium. Although I have detailed this concept on a number of occasions, it seems important to resurrect this framework again; not only to demonstrate the underlying framework for David’s argument, but also to show that this view is consistent with the Austrian business cycle theory.

The concept of monetary equilibrium is rather simple. Monetary equilibrium is defined as the case in which desired money balances are equal to actual money balances. Let’s begin in equilibrium and then describe monetary disequilibrium.

Recall the equation of exchange:

MV = PY

where M is money, V is velocity, P is the price level, and Y is real output.

The two major sources of monetary disequilibrium are changes in the money supply (M) and changes in the demand for money (V). If M or V decline it is because of a decline in the money supply or an increase in money demand, respectively. This results in an excess demand for money — desired money balances are below above the actual supply. Ceteris paribus a reduction in M or V will result in a reduction in PY, or nominal spending. Since prices are not infinitely flexible, this also implies that at least part of the reduction in nominal spending will be a reduction in real GDP. Thus, it is not that David Beckworth thinks that evermore nominal spending would create prosperity, eliminate poverty, cure cancer, and turn Bob Murphy into a monetarist, but rather that the reduction in nominal spending reflects an excess money demand problem.

How can excess money demand be eliminated?

Excess money demand is reflected in a reduction in M and/or V. In a world with a central bank, monetary policy can eliminate excess money demand by reversing the reduction in M or offsetting the reduction in V. In either case, the central bank is increasing the money supply so that actual money balances increase to equal desired money balances. This is the point that David Beckworth is making.

An alternative way of thinking about monetary equilibrium is to use the interest rate rather than the money supply as a guidepost. If we define the interest rate that reflects the underlying preferences and real factors of the economy as the natural rate of interest and the interest rate that actually exists in everyday activity the market rate of interest, we can then define monetary equilibrium as the case in which the natural rate of interest is equal to the market rate.

So why is the equivalency important? Allow me to quote, at length, a wise monetary economist that I know:

The monetary equilibrium tradition is largely a European one. Much of the work on the doctrine prior to Keynes was in the hands of Swedish, British, and Austrian economists. Arguably, the whole approach begins in Sweden with the work of Wicksell, an in particular his development of the concepts of the natural and market rates of interest.

[...]

Wicksell saw himself as rescuing the Quantity Theory from what he saw as overly simplistic treatments that ignored the process by which monetary changes manifested themselves both in the price level and in real effects…

Wicksell’s work had a clear Austrian connection in its reliance on Bohm-Bawerk’s theory of capital in developing the concept of the nature rate of interest.

[...]

Hayek’s relationship with monetary equilibrium theory was also somewhat ambiguous. In some of his early writings, he defended a constant supply of money and appeared to agree with Mises’ claim that the creation of fiduciary media would disequilibrate the real capital market. On the other hand, as Selgin (1988a: 57) points out, there are numerous passages in Hayek where is recognizes that the nominal money supply should adjust to changes in the demand to hold money balances…in the second edition of Prices and Production, as we shall discuss later on, Hayek clearly call for changes in the money supply that offset movements in velocity so as to stabilize the left side of the equation of exchange. He was skeptical of the ability of any banking institution to actually accomplish this task, but he does indicate that this is desirable norm. Even as late as his 1978 book The Denationalisation of Money, he argued that:

A stable price level…demands..that the quantity of money (or rather the aggregate value of all the most liquid assets) be kept such that people will no reduce or increase their outlay for the purpose of adapting their balances to their altered liquidity preferences.

In other words, Hayek is arguing that in response to change in the demand for money (liquidity preferences), the monetary authority ought to adjust the supply of money so as to head off a scramble to obtain, or rush to get rid of, money balances.

That lengthy quote is taken from Microfoundations and Macroeconomics: An Austrian Perspective by Steven Horwitz (p. 75 -79). Thus, it is curious that Murphy would write:

As I mentioned in the introduction, this is why intellectually consistent conservatives are defecting to the Austrian camp. They can’t listen to their favorite AM radio hosts or TV pundits blast away at the stupidity of Keynesian deficit spending, and then turn right around and champion Bernanke’s attempt to stimulate aggregate demand.

What David Beckworth is arguing is that we must maintain monetary equilibrium, which is precisely what Hayek suggested was the optimal type of monetary policy not only in Prices and Production, which articulates in great detail the Austrian business cycle theory, but also in his work nearly a half-century later.

So what precisely is the Austrian critique? Murphy seems to be suggesting that any increase in the money supply generates inflation and distorts the capital structure. That view might fly with a certain band of Austrians, but it is not consistent with Hayek’s articulation of the Austrian business cycle theory and it is not even consistent with a free banking system in the absence of a central bank. Under a free banking system, banknotes would be redeemable in terms of a particular commodity. It follows that banks would routinely vary their level of reserves in accordance with the demand for money.

My objective in discussing this issue is merely to point out that David’s argument is not that more nominal spending is always better. Rather, it is the concept of monetary equilibrium that is at the center of David’s claim that quantitative easing is necessary. Accordingly, rapid declines in nominal spending reflect a deviation of desired money balances from actual money balances and, as a result, require monetary expansion to correct. In addition, this concept is not only at the core of David’s argument, but also at the core of the Austrian theory of the business cycle as articulated by Hayek and others.

Thus, Robert Murphy is free to support (or oppose) whatever policy he desires. The astute reader will note that I have not advocated a particular policy in the post. I have not done so because the purpose of the post, as with so many since the recession began, is to explicitly outline a framework rather than a caricature thereof. If one is to advocate the Austrian position and argue that David is wrong, the argument must take seriously the concept of monetary equilibrium and recognize that this concept was also at the core of Hayek’s thinking. Such an advocate would therefore have to explain why Hayek’s policy prescription was not consistent with the business cycle theory that he contributed so much to developing; or, alternatively, that we are not currently in a state of monetary disequilibrium.