November 24, 2014

Money and The Business Cycle

Money and The Business Cycle
Gregory T. Bogosian
            Money is critical to any market economy because money allows people to exchange property without direct barter. Thus money facilitates and accelerates transactions, and thus accelerates the market process in which the highest valued use of every good, service and commodity is found. Money is also necessary for people to do proper accounting to determine whether they are making a profit or a loss on their current economic activity. It is this accounting that allows firms to discern whether they are in the right industry, making their product the right way, and selling it at the right price.  Money is whatever is used for buying and selling things. In other words, money is the medium of exchanging property rights and keeping account of the profits and losses from those exchanges. There are seven criteria that something must meet to be used as money. 1. It must be widely valued so that people will be willing to trade away other valuable things to get it. 2. It must be easy to transport so that people can get it to the physical trading site where they can buy what they want. 3. It must be scarce enough so that small, easy to carry and measureable amounts of it can be used to complete most transactions. 4. It must be imperishable so that people can save it long enough to find a use for it that they judge to be worthwhile. 5. It must be easy to store so that people can always put it somewhere safe when they are not using it and retrieve it immediately when there is a transaction that they want to complete. 6. It must be easily divisible so that people can make change in any transaction and pay the exact price of whatever they buy. 7. Every unit of it must be interchangeable so that people can always tell how much they are paying or receiving in any transaction. The relationship between money and the overall economy has critical implications for public policy. Every major school of thought identifies money as a key element in the business cycle. The business cycle is the periodic fluctuation of the overall amount of output that is bought and sold and the resulting fluctuation in unemployment.
            Every country imposes a monopoly on the creation of money within its own borders. In most developed countries the government delegates its power to create money to an agency called a central bank. Central banks create money by buying financial assets, usually government bonds, from private banks with money that did not exist before the purchase. Private banks then use the new money that they made from selling the assets, called reserves, to make loans. Banks do not actually loan out their reserves or the money of their depositors. Rather, banks create the money that they loan out at the moment that they make the loan by simply entering it into their ledgers. What stops banks from loaning out infinite money and rendering the currency useless is that every country imposes a legal limit, defined by the ratio of reserves to deposits, on the amount of money that banks can have in outstanding loans. This method of controlling the money supply is called fractional reserve banking. This may seem to contradict the government having monopoly on the creation of money. However, the central bank still controls the overall money supply by controlling the amount of available reserves. Thus the central bank and, therefore, the government still maintains de facto control over the amount of money in circulation at any given time. In economics there is a fevered debate about the role of the central bank in the business cycle. The Keynesian school of thought teaches that central banks should use their power to create money to smooth out fluctuations in aggregate demand, or total spending, in order to maintain full employment of labor and other resources. Keynesianism teaches that prices do not adjust to clear the market fast enough in response to changes in total spending. The Austrian school maintains that Keynesianism cannot tell us why aggregate spending fluctuates at all. Keynesians usually argue that booms and recessions are self-fulfilling prophecies. When people believe that the economy is doing well, they assume that they will have higher income in the future. This encourages people to spend and invest more money, which leads to actual higher future income.  Equivalently, Keynesians argue that when people believe that the economy is getting worse, they assume that they will have less income in the future and thus cannot afford to spend as much money in the present, thus causing a recession. Austrians counter by arguing that Keynesian theory provides no explanation for why people’s expectations about the future of the economy and thus the future of their own personal finances change at all. Thus Keynesianism cannot explain why we do not have either a perpetual boom or a perpetual recession.
            The Austrian school teaches that prices adjust to clear all markets, including the labor market, on their own in both the short run and the long run. Thus equilibrium in the labor market, otherwise known as full employment, is compatible with any amount of money in the economy according to Austrian theory. The Austrian school teaches that the ultimate cause of the business cycle is the government monopoly on money which it exercises through the central bank. By manipulating the money supply, the central bank misleads entrepreneurs about the amount of investment that the savings rate will support. The Austrian school teaches that the business cycle will not occur and unemployment will not fluctuate so long as the real interest rate, the interest rate adjusted for inflation, accurately reflects the consumer’s willingness to sacrifice future consumption for present consumption by borrowing money and paying interest. Equivalently, the economy shall operate at full employment if the interest rate accurately reflects loaners’ willingness to sacrifice present consumption by saving and loaning out money for future consumption, made possible by repayment of the loan plus interest. In other words, the economy will operate at full employment so long as the interest rate equals the opportunity cost of additional loans. The Austrian school teaches that the central bank causes booms by lowering the interest rate to below optimal levels and thus causing more money to be loaned than the consumer’s saving can finance. This leads to entrepreneurs overestimating the consumer’s willingness to save, thus overestimating their willingness to pay for goods in the future. This makes entrepreneurs borrow too much money and spend too much money on new capital goods, thus devoting capital goods to the production of consumer goods that consumers do not want. The boom inevitably leads to a recession once entrepreneurs realize that people do not want to buy their products and that the interest rate does not accurately reflect people’s desire for future consumption. So the boom lasts until entrepreneurs realize that the central bank has fooled them and the recession lasts until the central bank discovers a new way to fool entrepreneurs. Thus the boom inevitably transforms into a recession as entrepreneurs realize that their investments will not pay off because people are not willing to spend as much money as the interest rate indicates. This raises the question of why entrepreneurs cannot tell when the central bank is lowering the interest rate to below optimal levels and thus deduce that they should not buy as much capital as they would buy otherwise. The answer is that the central bank’s control over the real interest rate ensures that neither entrepreneurs nor anyone else can ever tell what interest rate truly reflects the consumer’s willingness to sacrifice future consumption for present consumption by borrowing money and paying interest. Thus entrepreneurs never know whether the interest rate is above the correct level or below the correct level until after the fact. Governments pressure central banks into lowering the interest rate and thus creating booms because this makes it easier for governments to borrow money and thus finance politically important projects.
            The Austrian prescription for ending the business cycle is to eliminate the government monopoly on currency entirely and allow private banks to issue their own currency backed by gold or some other commodity that satisfies the seven criteria for being good money. Austrians argue that if each bank could issue its own currency backed by gold, then the central bank would be unable to manipulate interest rates and the interest rate would reach the level that accurately reflects the opportunity cost of making an additional loan on its own. If their currencies were backed by gold, then banks would not issue too much of their currency and thus not create lower than optimal interest. Any bank that issued more currency than their gold reserves support would provoke their competitors into buying their currency and redeeming it for gold that the issuing bank does not have, thus bankrupting the issuer and running them out of business. Thus the private banks would effectively regulate each other if they issued their own gold-backed currencies.  The normal argument for the government monopoly on money is that having only one currency rather than many currencies reduces transaction costs by removing the need to switch between currencies. The problem with this argument is that it only makes sense under the assumption that the currency market is a natural monopoly. If that were the case, then only one currency would endure and the government would have no need to give itself a monopoly on money to create a single currency economy. Moreover, the market has internalized the transaction costs of switching between currencies of different countries through the foreign exchange market. There is no obvious reason why an equivalent domestic exchange market would not emerge if the government ended its monopoly on currency and private currencies emerged. Once the transaction costs of switching currencies are internalized into a competitive market they cease to be an impediment to economic efficiency. In summary, the Austrian theory of how money relates to the business cycle implies that the optimal response to the business cycle is not actively manipulating the money supply because active manipulation of the money supply causes the business cycle. Rather, the optimal response is to eliminate the government monopoly on money and to trust that the market will produce the optimal amount of money on its own.

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