Austrian Economics Forum Spring 2011 #3--Non-Neutral Money

This session we had three readings: “The Non-Neutrality of Money” by Ludwig von Mises (1938 [1990]), “Neutrality of Money” by Don Patinkin (1987/1989) and “The Problem of Monetary Equilibrium,” by J.G. Koopmans (1936).  We started with Mises’ article and, sadly, ran out of time before we could really get into the Koopmans piece.  The Koopmans piece is a lecture that he gave at the LSE on June 15, 1936.  The copy we used comes from Professor Richard Ebeling.  He hopes that it will be soon published as a journal article.  We shall see.

The idea of money's non-neutrality seems to be fairly straight forward, while the idea of neutral money is the idea that seems to be alien.  Nevertheless if we examine the economics profession, the idea of non-neutral money is almost summarily rejected or, on a good day, it is given some lip service--and then tossed aside.  So what is neutral money and where does the idea come from?

In the mid-1700s, David Hume (Scottish philosopher and teacher of Adam Smith) was arguing against mercantilism.  Mercantilism was the political economic doctrine that held that a nation is richer if it has more gold and silver.  These riches could then be transformed into military power and then ultimately into national supremacy.  Hume argued that the wealth of a nation could not be simply measured by counting the amount of money (gold and silver) that existed in the economy.  He said that ultimately wealth was found in the goods and services in a country and not the amount of money.  For example, suppose that an economy doubles its money supply overnight.  Is it doubly as rich?  The obvious answer is, "No, all that changes is prices."

So far the neutral and the non-neutral money theorists agree.  The next step is where the two groups part company.

The neutral money theorist says that if the money supply doubles, then all prices will double.  The modern version of this position is that the "Price Level" doubles.  In other words, on average, prices will double. 

The non-neutral money theorist says that this analysis is drawing conclusions with assumed facts.  The neutral money supporter is implicitly assuming his conclusions: increasing the money supply has no effects on anything real. 

So let's get into the details of the debate.

First of all, the Austrian asks what is meant by the "Price Level"?  Mises explicitly rejects the metaphorical use of the term "level."  It conjures up an image of a pool of water in which water is added or withdrawn.  The height of the water in the pool then reflects the change in the injections--i.e., a doubling of the amount of water, doubles the height of the pool's level.  Money is not diffused into an economy so quickly.  Hayek has said that instead of water, we might envision the pouring of honey.  Mises argues that positing all prices and wages simultaneously rising or falling to the same extent simply cannot be assumed. 

Patinkin, on the other hand, argues that nothing other than exactly that can occur.  He sets up a general equilibrium model of an economy and then increases the money supply by "k."  He then shows, mathematically, that in order for all the equations to reequilibrate, all prices and wages must increase by exactly "k."  The assumption is made at the moment when we assume unique general equilibrium conditions.  If there is only one solution for general equilibrium, then of course the only solution is to change prices by "k."  However, that is a huge assumption that is never (rarely?) justified.  In his defense, Patinkin does admit that in the short-run there may be some non-neutral effects, however, his argument is that the long-run patterns must reemerge.

But, let's take Patinkin at face value.  The entire focus of Austrian analysis is on the short-run effects of monetary injections and their distortionary effects.  So, why should the Austrian even take the bait and argue the implications of a hypothetical long-run, which will never emerge?  Furthermore, as we will see below, the role of heterogeneous capital will make returning to an original hypothetical long-run equilibrium impossible.

So then what is the Austrian position and why is it so important?

The Austrians do not view money as some mystical numeraire that simply measures the height of purchasing power.  Instead, money is a good that is also subject to the same laws of diminishing marginal utility (demand) and increasing opportunity costs (supply) that govern all other goods and services.  Since the valuation of money is governed by marginal appraisals and the goods and services purchased are also governed by marginal appraisals, then the concepts such as "Price Level" and "velocity" must be viewed with extreme suspicion.  Indeed, Mises outrightly rejects the use of either.  Mises states,

Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems.  The monetary economist does not have to deal with universal entities like volume of trade meaning total volume of trade or quantity of money meaning all the money current in the whole economic system.  Still less can he make use of the nebulous metaphor "velocity of circulation."  He has to realize that the demand for money arises from the preferences of individuals. ... Money is never simply in the economic system, ..., money is never simply circulating. ... The decisions of individuals regarding the magnitude of their cash holdings constitute the ultimate factor in the formulation of purchasing power.

As a result, it makes no sense to aggregate all of the money into a graph containing Money Supply and Money Demand to determine the "Purchasing Power" of money.  Furthermore, the Austrians reject the "equation of exchange," MV = PQ. 

So without such mechanisms for analysis, what is the proper method for examining macroeconomic and monetary problems?

The Austrians use a stepwise approach.  Austrians argue that money is injected into specific points into the economy and that these injection effects have specific impacts and implications.  Suppose that the central bank creates and injects new money into the economy.  Economists agree that this money creation favors debtors and harms creditors.  Additionally, economists agree that a signal extraction problem might emerge; that it is a hidden tax and can distort the incidence of the tax code; and that it can blossum into hyperinflation, which can be very difficult to reverse.  However, the Austrians focus on the emergence of the Cantillon Effects. 

If the central bank creates $100, it is injected into the economy and not scattered evenly throughout it.  As a result the first person (firm, institution, etc.) to get the new money has an advantage over everyone else.  He is able to obtain $100 worth of goods and services at today's prices without first contributing to the general welfare.  The buyer who uses this new money competes against everyone else in the economy.  The effect of his purchases is an increase in the demands for those specific goods, resulting in the prices for those goods inching up.  Now those who have the new money are able to buy goods and services with only some prices slightly higher.  The effect ripples through the economy.  As the new money passes from person-to-person, prices inch up as a real goods and services are exchanged. 

While this process continues there are those people who do not yet have the new money.  Nevertheless, the prices that they face are rising.  Their real wealth falls.  Thus, there is a real wealth transfer from those who get the new money last to those who got the new money first. 

The next step is to add heterogeneous capital to the analysis.  To the degree that capital has specificity, these distortionary effects create illiquid malinvestments.  As these malinvestments are built up in the economy, their removal becomes more difficult.  This idea is the underlying framework for Austrian Business Cycle Theory.

None of these issues emerge if money is assumed to be neutral.  Indeed, many economic problems become difficult to analyze when neutral money is assumed.  This is probably why Mises concludes his article with this important observation:

I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money.  Money is non-neutral or it does not exist.