I’m writing this post on Austrian macro because the Austrian school seems to be both en vogue with and poorly understood by Tea Party types. For that matter, it is poorly understood by critics of the Tea Party. I’ll be the first to admit that I am not the most qualified person in the world to write this post. I am not an Austrian or a macroeconomist. Lots of people, including some GMU first-years who are taking the macro prelim this weekend, could do a better job than I will do. Maybe they can comment and refine the post that way. Let’s get started:

What’s right with Austrian macro?

The starting point for modern macroeconomics is what is known as dynamic stochastic general equilibrium (DSGE) models. These models vary depending on the point that the theorist is trying to make, but in the broadest class of them, there is in fact very little economics even going on. Say we start with Long and Plosser’s classic RBC model. How many goods are there in Long and Plosser? One (plus leisure). How many people are there in Long and Plosser? One! How much trade is there in Long and Plosser? Zero. Now, if what you mean by economics is intertemporal optimization in the face of random shocks, then Long and Plosser is an economic model. But as Hayek argues, “This, however, is emphatically not the economic problem which society faces.” DSGE models are poorly suited to evaluating changes in an economy with arbitrarily diverse agents with arbitrarily diverse preferences and arbitrarily diverse information sets. This critique of DSGE-style macro is part of the core of Austrian theory.

Furthermore, in the Austrian view, capital is heterogeneous and multi-specific. If you invest in a pet store, and then decide you want to convert it to a massage parlor, that is costly and time-consuming. This opens the door to malinvestment. In many RBC and New Keynesian models, capital is homogeneous, meaning that it is costless to switch from one investment into another. Kydland and Prescott explicitly assume time-to-build, but this is not the only friction in real-world investment.

According to the Austrians, production functions for the multi-specific capital are discovered over time. In virtually all RBC and New Keynesian models, production functions, the way of transforming the single type of capital into the good or (rarely) goods are specified in advance and do not change. Austrians emphasize competition as a discovery procedure. Entrepreneurs are constantly trying to find new ways to turn existing capital stocks into goods that consumers may want. This discovery procedure is obviously sensitive to policy shocks.

What is wrong with Austrian macro?

The biggest problem with the Austrian school is a legacy of the fact that much (not all!) of the theory was developed before the rational expectations revolution. Even if you think rational expectations is bogus, the fact is that many Austrian models do not explicitly state what is driving expectations. If the monetary authority inflates, everyone is tricked. This is clearly problematic. A better Austrian theory in my opinion would evolve along the lines of the Lucas islands model. I have written before that I think our current situation is one of severe model uncertainty. Some people think money is tight and others think money is loose. If that is the case, then even if people have, say, Bayesian expectations, many of them will be tricked, resulting in monetary distortions.

The other major weakness in Austrian business cycle theory is that it focuses way too much on one particular distortion, monetary policy. Now, the Austrians have an answer to this; they argue that money is one half of every single transaction in the economy, so if money is distorted, then that is a big problem. I don’t think this is true. First, monetary distortions will cause primarily intertemporal distortions. This may be problematic, but as I wrote above, one of the biggest strengths of the Austrian model is that it takes seriously the heterogeneity of goods, capital, and preferences. Focusing primarily on intertemporal investment gives away that huge gain. Austrians should be more open to examining other distortions, such as the subsidization of fixed-value financial claims (FDIC insurance, favoring debt versus equity) and industrial policy. I think Arnold Kling is onto something with his emphasis on Patterns of Sustainable Specialization and Trade.

What is misunderstood about Austrian macro?

The Austrian mantle has been claimed by the Tea Party, but very few Tea Partiers are familiar with modern Austrian scholarship. Michelle Bachmann famously takes Mises with her to the beach, but there is a great deal of Austrian theory that is post-Mises. In particular, most of the modern Austrians I have talked to are not goldbugs. They understand that the most important characteristic of money is not its store-of-value property. In general they favor rules versus discretion in monetary policy, but those rules are ones that non-Austrians can easily get behind. For instance, George Selgin writes, “Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.” Furthermore, to the extent that Austrians like gold as currency, they like it because they believe it would “win” in a free-market competition against fiat currency, not because gold is special per se. A simple test would be to get rid of capital gains taxes on gold and other assets and see what wins.

Modern Austrians view policies like NGDP targeting as coming straight out of Hayek, who wrote about the importance of preventing a “secondary deflation.” Consequently, the mainstream accusation that Austrians favor no policy in the face of a financial crisis is misguided. The correct policy, according to many Austrians, is to adopt the most non-distortionary monetary policy there is, which is to keep nominal spending at the expected level. Letting spending collapse is itself a distortionary policy.

The Tea Party is populist, but it seems to be populist for the sake of populism. Austrian theory, on the other hand, is anti-elitist because it believes that neither elites nor anyone else can successfully “manage” the economy. There is consequently a certain populist interpretation of Austrianism; but the theory is not so much about giving the masses what they want as about letting a decentralized process take place. This is the main reason I am skeptical about the political adoption of Austrianism. It is being used as a rhetorical tool in a cultural dispute, not as a way of understanding the nature of the economic problems we face.

The argument for getting rid of the debt ceiling goes like this: Congress has already approved federal spending. Increases in the debt ceiling merely authorize the executive branch to spend what the legislative branch has ordered it to spend, so it is redundant. Furthermore, Congress has now discovered that the debt ceiling can be used as a source of gridlock (or “hostage-taking” or “terrorism,” depending on how shrill you want to get). Most governments don’t have debt ceilings; they work just fine. So the debt ceiling creates an opportunity for political opportunism and pointlessly increases our risk of a big crisis.

This argument strikes me as shockingly naïve. First of all, to get rid of the debt ceiling would be to vastly expand the power of the executive branch. The US Constitution lists borrowing as an Article I power. “The Congress shall have Power…To borrow Money on the credit of the United States.” Giving the executive branch the power to borrow on the credit of the US whatever it interprets to be necessary could have terrible consequences. For instance, current Constitutional jurisprudence seems to give Congress the authority to declare war, but no mechanism by which to undeclare war. Wars end when the executive branch says they end. However, at present Congress can at least de-fund a war. If the debt ceiling were eliminated, once war had been declared, the executive branch could prosecute it basically forever, even if Congress disapproved. The president could borrow whatever money was necessary to do all the spending that Congress ordered, plus the money for the war. And when you factor in that the Obama administration seems to have blatantly ignored the War Powers Resolution in its action in Libya, this should be cause for serious alarm among anyone with even a modicum of sense. The left especially, which complained incessantly about expansions of executive power during the Bush administration, if it has any principles left should oppose giving the executive branch any freer rein.

Furthermore, it’s simply not true that every Congress approves of all federal spending. Congress passes a discretionary budget every year, but much of federal spending is “mandatory,” meaning it is not subject to the ordinary how-a-bill-becomes-a-law process. On entitlements, for instance, some past Congress approved a given path of spending, but the current Congress can only change that path if they can override a presidential veto (or induce a non-veto). Assuming no veto-overrides, to cut discretionary spending, you need both houses of Congress. To cut entitlement spending, you need both houses plus the President. So the structure of the spending power is in fact different with discretionary versus “mandatory” spending. Faced with an executive branch that opposes cuts to entitlement spending, Congress will never be able to cut spending if they cannot force a cut through the debt ceiling. If all federal spending were discretionary, then there would be some merit to the claim that the debt ceiling is redundant; since some spending cuts are subject to a presidential veto, the debt ceiling provides an important non-redundant tool to force those cuts.

More generally, I would remind people that decreasing the holdout problem with respect to spending increases the holdout problem with respect to cutting spending. If you agree that the US needs to drastically cut entitlements over the medium term (i.e., if you are paying attention), you should want to decrease the holdout problem for spending cuts, not for spending increases.

So what about the severe crisis that will result if the US bumps up against the debt ceiling, gets downgraded, or delays payments? I agree that this will be a manufactured crisis, but those who favor spending more seem to deserve as much, if not more, of the blame as those who oppose borrowing more. But it seems the biggest blame should be laid at the feet of those who make our economy so fragile with respect to a single security. The best way to avoid a crisis in the future is to take steps now to make financial institutions more robust. First, eliminate rules that will trigger huge sell-offs of T-bills if when the US loses its AAA credit rating. Eliminate the favorable tax treatment of debt and improve the tax treatment of equity (I facetiously call this “Islamic banking lite”). Allow checkable brokerage accounts. Increase the average maturity of US debt to give the government some leeway with respect to seigniorage in the event the crisis occurs.

And of course, the ultimate solution to the debt ceiling issue is to spend less. Even if you oppose cutting spending during a recession, it’s hard to justify a debt ceiling that is as high as the US’s. If the output gap of a recession is 8 percent of GDP for 4 years, even if there is no monetary stimulus, that justifies a debt ceiling that is 32 percent of GDP, not 100 percent or more. In reality, there can be more monetary stimulus and fiscal stimulus is pretty ineffective, so even 32 percent of GDP seems like excessive borrowing across the business cycle.

My bottom line is that the US is a big, diverse economy. As it has gotten more diverse, interests have come into greater conflict. The result will be either gridlock in Congress, consolidation of executive branch power, or devolution of power to local authorities (at which scale there is less conflict) and the market. We should take this last path, and the quickest and least painful way to get there is to keep the debt ceiling and make smart reforms to spending and the financial system. Eliminating the debt ceiling will ensure that power continues to be consolidated and that spending will be harder to cut.

The total supply of Bitcoins is scheduled to grow geometrically and will asymptotically approach 21 million. This means that if the currency becomes successful and its velocity does not accelerate proportionally to its use, we should expect long-run deflation in Bitcoin-denominated prices. Bitcoins are technically divisible to 8 decimal places to accommodate this. Notably, if I am reading the data correctly, Bitcoins have appreciated by a factor of 300 against the dollar in the last year. One Bitcoin is worth around 88 cents as of this writing.

I have a number of questions. Perhaps my readers know some of the answers, or perhaps some enterprising young monetary economist will address some of these in an academic paper (calling Will Luther).

1. Currencies are based on trust, and trust in money is accomplished through scarcity. Bitcoin is cryptographically guaranteed to be scarce since its supply will never exceed 21 million. But there is reason to believe that a perfectly fixed supply is not optimal. If people suffer from money illusion, it is better if prices increase gradually over time. If money has real effects, then it is best if the money supply is countercyclical. These two facts are at least part of why Sumner advocates a fixed NGDP trajectory. Is it possible to create a cryptocurrency that targets NGDP instead of the money supply?
2. If there are competing currencies would we still want any one currency to target NGDP? MV ≡ PT, but notably T only represents transactions denominated in a particular currency. In general, what is the optimal path of the various money supplies when there is more than one currency in use in a given economy? When there are competing currencies, is there less money illusion? Does money continue to have real effects?
3. What are the monetary implications of the fact that governments will probably have difficulty regulating banking in cryptocurrency? Does cryptocurrency provide a test of the legal restrictions theory developed by Fischer Black, Neil Wallace, and others?
4. What if prices come to be denominated in Bitcoin (with its fixed supply), but different media of exchange and settlement are used? How does that change any of the above?
5. In a number of the above scenarios, there may not be much deflation in Bitcoin-denominated prices (since the money supply is not defined, say, under the absence of legal restrictions on financial intermediation). Putting these scenarios aside, if deflation were consistent, then Bitcoins would yield a positive return due to appreciation. Would we see more money hoarding during recessions? Would the world finally see a real liquidity trap? With monetary policy out of the picture, would fiscal policy become necessary? Is crypto-anarchy self-defeating because it requires big government interventions?
6. Decentralization of the currency means that it cannot be debased, but it also means that it cannot be confiscated at an institutional level. What are the political effects of this change?

I suppose I should add that I am not exposed to Bitcoin and am long USD. And by the way, thinking about Bitcoin reminded me of David Friedman’s Future Imperfect, which you may want to read if you enjoyed this post.

Update 4/4/11 — Bitcoin is the subject of today’s EconTalk.

Here is my ranking of monetary regimes:

1. Depoliticization and denationalization of money. Free banking. The market selects a currency and banking is “regulated” in court under the common law of contract.
2. The Fed is a Sumnerian robot. It runs a market in quasi-velocity futures and a computer uses the market price to decide whether to expand or contract the money supply.
3. The status quo.
4. Congress itself “coin[s] money and regulate[s] the value thereof.”

Most people who want to abolish the Fed think that we can go from number 3 to number 1, but more likely, if we End the Fed, we’ll go to number 4. For all the exaggerated claims about how the Fed is turning us into Zimbabwe, number 4 would go much further in that direction than number 3 has.

If anti-Fed steps are to be taken, they should be along the lines of Ron Paul’s Free Competition in Currency Act, which weakens the Fed by eliminating legal tender laws and eliminates capital gains for alternative currencies. The capital gains issue is important because money is half of every transaction, and even if the value of money is stable such that there are minimal capital gains and losses, the amount of record-keeping that is needed to use an alternative currency is prohibitive. The bill doesn’t go far enough, though; the optimal currency may be none of the things that are exempted from capital gains taxes under the bill, and really the only solution is to eliminate taxation of capital gains entirely. Can you imagine the political uproar from our friends on the left?

People complain that since the inception of the Fed, 95% of the purchasing power of the dollar has been inflated away, but this is looking at the wrong derivative. When inflation is consistent and expected, rates of return adjust to compensate for it. As long as you are not holding most of your assets in currency or non-interest-bearing dollar-denominated accounts, steady inflation doesn’t matter. Inflation is a tax on people who hold literal dollars, which is probably not you unless you are a crime lord or a foreign dictator.

QE2 brings us slightly closer to the number 2 monetary regime above, and I support it on those grounds and those grounds only. If we had had the Sumnerian infrastructure in place in early 2008, it would be telling us to expand the money supply now, and therefore expanding it now is what we should do. I regret that it is being done on a discretionary basis, but you give policy advice in the policy environment you’ve got.

By the way, QE1 was not really QE, as Alex Tabarrok explained in 2008. The Fed started paying interest on reserves, which has the effect of massively decreasing velocity. The Fed needed to increase M to offset the decrease in V. Why the Fed would take such velocity-decreasing action in the middle of a crisis, I do not know.

Tyler Cowen writes this morning that if you want a countercyclical money supply, you must have a central bank. Tyler, this is false! I had a discussion once with a different Tyler in which we traced the effects of using shares of the S&P 500 as currency. Since the stock market is cyclical, money would appreciate in booms and depreciate in busts, just as it would if you had a decent central bank. The big downside would be a long-term deflationary trend, but nevertheless as a proof-of-concept it shows quite clearly that a countercyclical money supply is possible under a commodity currency.

For those who are opposed to monetary central planning, the real story is not QE2, but the looming disaster in the Eurozone, which is quite obviously not an optimal currency area. If they can get past the current crisis somehow, they will just be inviting the next one if they do not do something radical like banning all languages other than English. I’m still hoping that if the Greek collapse comes, it comes when I am in Greece next month.

The bottom line is that whether the Fed has been a failure depends on what you think the alternative is. The Fed made some big mistakes in the 1930s and in 2008-2009, but at least (1) we’re not Europe and (2) Congress is not in charge. I think that if we give in to populism, we are likely to get something worse than the Fed, not better, though if the populists want to start getting serious about monetary theory, I would welcome that.

Nor do I find the central story of how the FDIC induced this moral hazard very compelling. Supposedly, ordinary depositors don’t bother to check the soundness of their banks because they don’t actually have skin in the game.

Anyone making this argument cannot have met many ordinary depositors. If you stripped away my mother’s FDIC protection, she wouldn’t do any better of a job at evaluating Citigroup’s finances.

(HT: Scott Sumner. See his reply here.)

I don’t know Megan’s mother, but I suspect that this is correct. The problem with Megan’s argument, however, is that it is a partial equilibrium analysis. It is an extrapolation of what would happen if the FDIC were shut down and nothing else changed. A better way to approach the issue is to look at what changes the elimination of the FDIC would induce in the banking system: what would be the new general equilibrium?

Without FDIC protection, Megan’s mother and millions like her would probably not feel comfortable lending money to banks as we know them today, which would be prone to runs. Depositors have fixed claims, and banks have variable assets. Without deposit insurance, when people start to suspect that their bank’s assets have declined (that the bank is no longer solvent), they rush to withdraw their deposits. Because the bank is leveraged, this causes insolvency, whether or not the bank was insolvent in the first place.

An alternative to this model is described by Cowen and Kroszner in their 1990 Cato Journal article, Mutual Fund Banking: A Market Approach. They argue that in the absence of deposit insurance, depositors would seek alternatives to traditional banks that do not suffer from the tendency to experience runs. One such approach would be mutual fund banking.

We examine mutual fund banking as an alternative form of financial intermediation. Individuals would hold checkable deposits at financial intermediaries structured as mutual funds. Although the nominal value of depositor holdings would not be fixed, risk could be hedged through the choice of portfolios.

Here is the money quote:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

If Cowen and Kroszner are right that something like this would evolve in the absence of deposit insurance, and I think they are, then moral hazard would be greatly reduced by eliminating the FDIC, even if ordinary depositors are incapable of performing a significant monitoring function.

What intrigues me, however, are the implications Sumner’s view has for macro and monetary theory. Sumner is arguing that monetary policy was tight in 2008, while most other economists would argue that it was loose. In a recent post, Sumner suggests that there is no persusasive metric of monetary stance. Nominal interest rates can signal monetary stance or inflation expectations. Real interest rates were high in late 2008, but most economists think monetary policy was loose. Other indicators have their own problems.

If even economists disagree about whether money is tight or loose, what hope do ordinary producers and consumers have of preemptively adjusting to monetary policy? If people are genuinely confused about the stance of the monetary authority, this breathes new life into a class of economic models that the profession has discarded and ignored in recent decades, epitomized by the Lucas-Islands model. In the Lucas story, as I remember it, producers observe changes in demand for their products and change their production, factoring in all expected changes in inflation. If inflation is expected, then producers who observe increased demand for their products won’t be tricked into increasing production—they will realize that only nominal, and not real, demand has increased. If inflation is unexpected, producers will think the observed increase in demand is real, not just nominal, and increase production accordingly. The model therefore establishes a link between unanticipated inflation and the real economy.

The Lucas-Islands model has fallen out of favor because of the simple criticism that it is trivially possible to observe the open-market operations of central banks. On any given day, it is easy to determine, say, the monetary base, or whether the Fed is buying or selling treasuries. Therefore, the story goes, no inflation should be unanticipated. Yet we observe in reality that monetary policy seems to have an effect on the real economy; therefore the Lucas model cannot be correct.

If, however, the actions of the central bank are not sufficient to determine the monetary stance, the Lucas model (or other monetary confusion models) could still be accurate. One would have to assume that errors are clustered, but that is compatible with rational expectations. Throw in heterogeneous K and you are most of the way to Austrian business cycle theory. The logical conclusion is that economists ought to reexamine these macro models or incorporate monetary confusion into newer DSGE models (although they might then have to be renamed DSGD models). Unless someone is able to convince Sumner that monetary policy was loose in 2008 after all, it seems that taking monetary confusion more seriously is a promising way forward for macro.