Friday, December 14, 2007

A reply to hps: inflation, money, neutrality and all that (amv)

In my comment on Dullien I used a quite untypical definition of inflation. Inflation, so I did argue, is the increase in money supply. A reader of this blog - Prof. hps - posted a very interesting comment which I want to reproduce here:
"Well, turning scientific controversies into mere definitions is a sure-fire recipe of winning any debate, isn't it? But, to be honest, if the increase of the money supply (whatever that is - by the way, who "supplies" M3?) would show up (which is not to say: cause) rising prices as in the 70s, we would not bother about the demise of monetarism. Unfortunately however, we have a puzzle: money and goods prices seem to be disentangled. Even Friedman in his last paper, did not mention goods prices any longer, and confessed that he would not recommend any monetary targeting again. Clever fellows quickly redefine inflation so as to embrace asset prices. The Bundesbank assures us that by including real estate prices into money demand equations, velocity still performs as a stable variable - which comes down to saying that money and bricks are pretty much the same things. Somehow, in former times, monetary theory started to argue otherwise..."
The very problem of definitions and the concepts we employ in economic theory is that they are not neutral to the questions we ask and answers we gain in our inquiries. Definitions are abstractions and as such attempt to grasp the essence of things, that is, the most significant attribute of a thing shared by no other entitiy. It makes a difference in the stories we tell and the conclusions we reach if we define capital as a sum of money saved to be spend on future consumption or a structure of heterogenous capital goods which wear out and have to be either replaced or consumed. It makes a difference if I define money as a store of value (an attribute shared by many things we would not call money) or if we define money as the general medium of exchange. Thus, even though hps is right and monetarism indeed attempts to escape its poor predictions (and predictions are all that matter for Friedman and his modern followers) by shifting grounds, by becoming more than pragmatic, it would be hard for me to say all I want to say with the definitions that are developed for an entirely different theoretical framework. I am simply not a monetarist. So is my economic mother tongue not Friedman's.

Inflation as the general increase in prices (of consumer goods), is simply useless for the theoretical framework that I employ. It is, therefore, not a trick to win a dispute by shifting grounds. I totally agree with hps that monetarism has its problems, that the increase of any monetary aggregate seems to de disconnected from the trend of inflation (as defined by the mainstream). I am well aware of the fact that the actual money supply outpaces its reference value for years without leading to proportional increases in consumer good prices (even though momentarily these prices increase at a faster pace than targeted by the ECB). Thus, I do not try to defend any position within modern controversy. My theoretical framework is Austrian and strictly individualistic. So what do I want to say and why do I have to employ a different definition of inflation?

My attempt is to bring back macroeconomics into a strictly microeconomic context. Even though modern monetary economics talks a lot about rational choice and microfoundations, this is only lip-service paid which allows to use methods similiar to those of the microtheorist. But if we put the concept of choice on the top of our agenda, we have to accept that scarcity is there too. For individual choice makes only sense in a world in which our wants outpace our means. If macroeconomics is framed by choice, macrovariables like unemployment and output growth still exist but there is no macroanalysis to relate economic aggregates of any kinds. If methodological individualism is the framework employed, all we economists can say as economists is in terms of relative scarcities and relative prices. It is absurd that while the New Consensus in monetary theory does allow for individual choice between present and future consumption, this choice remains unrelated to the relative scarcities of the means employed to produce the goods to be consumed now or later. There is no intertemporal allocation of scarce means over and in time. No, if I dispose with consumption today there are no funds set free to reallocate labor to more remote processes. Labor and other resources just wait idle for the future (and thus effective demand) to come. How can relative prices coordinate scarce resources if the use of resources is supposed to be limited by effective demand? It is evident that prices in modern monetary economics are unrelated to genuine choice, that is, to the fact that we live in a world which offers its fruits only as alternatives! It is not surprising to find the Marshallian cost approach to prices and his representative firm at the center stage of modern macroeconomics which of course leaves out the crucial role of accounting opportunity costs, the comparision of utility gained (given by the marginal value product of any good in question) and utility foregone (those goods which cannot be utilized because the facors necessary to produce them are allocated to a different purpose).

In such a world, the neutrality of money as understood by most economists is merely a hypothetical case without much to reveal about existence. It is an empty concept without any reference to reality. If the equiproportionality of money and prices is all that can be meant with neutral money than there is no way to argue against all those insights behind hps's comment. But if we approach a scarcity-based macroanalysis (that is if we ask macroeconomic questions and answer them with microeconomics tools) the neutrality of money as equipropotionality becomes merely a special case of a much broader and more sophisticated understanding (more sophisticated than the monetarist approach) of what the anti-mercantlist tradition in economics has always been about.

If the economic problem is about relative scarcities and is solved by changing relative quantities by changes in relative prices, it is clear that no increase in the supply of money can add anything to escape the burden of scarcity. From the individual point of view, money is an asset, that is, is seen as wealth. And indeed, if we supply a single person with additional money his nominal constraint shifts and he can purchase more goods and serices. But this is entirely different if we approach the society as a whole. Since if there is more money circulating in the economy there is still nothing more to bid for. As already the Classics noted, increases in money should not be understood as an increase in wealth. Now the norrow definition of neutrality is of help to make this point obvious by making an auxiliary assumption: by a miracle, the increase in money supply is proportionally distributed among the members constituting the economy. Here it becomes most clear that the additional bids for real goods and services which stem from new money cancel each other out and that nothing has changed the relative scarcities felt throughout the market. But this proportionality-assumption is not necessary to make this point. Since if the shift in money supply is not evenly distributed among the members of the market society, different people can enforce their preferences and control upon the market. We have a redistribution towards those ends benefiting most and earliest from montary expansion. We have to face changing relative prices. Some prices rise, others fall. What happens to the price index of consumer goods is irrelevant. We have to see the entire price structure, that is goods of higher and lower order and the relation between them. Further, the Stock Exchange is equally important since it coordinates the capital structure. This modern theory would term non-neutral, while the Austrian approach implies neutrality of a different kind. As I claimed here:

More money allows the individual to purchase more, but more money cannot allow the society as such to consume more. More money is no substitute for real forces increasing our riches! And; I may now add, this we see most clearly if we define inflation as the expansion of money supply.

Thus, the most significant insight of the anti-mercantilist tradition since Adam Smith can be better grasped if we focus on neutrality in this broader sense. A by necessity arbitrary price index for consumer goods is only a second-best concept, employed by the the Curreny School, etc: The Quantity Theory is just a first step towards a better understanding of that matter. It has to be replaced by general equilibrium analysis based on relative scarcities if we want to be more clear about the Dismal message that you cannot increase the wealth of nations by printing money or by creating money by means of credit expansion.