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Pietro M.

I never followed Sumner closely, probably because I never found its proposals interesting. His economics is imbued with the hammer fallacy: when you have a hammer, everything looks like nails. Keynesians have the deficient aggregate demand hammer, monetarists the excessive money demand hammer, information economists the asymmetric information hammer.

Let's talk about the monetarists' favorite hammer, in this case: excess demand for money, or insufficient supply.

1. It should be recognized, from first economics principles, that money aggregates are largely endogenous. Banks create money when investments are perceived to be profitable and safe, when their balance sheet is sound, and when the central bank promises help in case of trouble.

When returns are low (capital goods are overpriced), interest rates have hitten the nominal floor, risk is perceived to be high and banks are financially unsound, there is nothing that can save monetary aggregates from crumbling down.

Because the reduction in profit margins is a natural consequence of excessive investment in durable capital, sooner or later a long boom will cause a situation in which banks will no longer be able to keep their level of intermediation.

This is what happened in Japan. This is what's happening now. This is what happens if one things in terms of Austrian theory, instead of assuming an exogenous "marginal efficiency of capital".

So, there is nothing that central banks can do to stimulate lending and keep the supply of money from falling in these conditions, except creating price inflation (so that the zero floor on interest rate is eliminate, creating negative real rates). And, of course, to avoid the "loan evergreening" problem of persistent malinvestment, it is better to avoid this at all costs. Japan is there as a warning of what happens when this doesn't occur.

This is a common misconception among monetarists. Friedman wrote here the same thing: http://www.hoover.org/publications/hoover-digest/article/6549

To treat an endogeneous process as a policy target is a mistake caused by a lack of microeconomic analysis of the determinants of the process.

2. The interest rate on reserves is 0.25%. Before believing this can create troubles, let's consider that it is not perceivably different from a straight 0%. This can only create troubles if there are no safe and profitable investment opportunities, i.e., if the economis is widely malinvested, and returns on investments are close to zero (risk adjusted).

But if returns fell some other 0.25%, the very same problems we have at 0.25% we would have at 0%. Where's the point? It's just an irrelevant zero dot something.

3. Banks are in bad financial shape, firms are in bad financial shape, consumers are in bad financial shape. How can this be considered a monetary problem, instead of a real one? Reducing financial leverage, outstanding debt, maturity mismatch, asset-side risks in opaque instruments... how could this market-level deleveraging be accomplished without macroeconomic effects by simply printing base money?

We usually need more than one hammer to understand markets. The monetarist hammer is, in our case, close to irrelevant.


Thanks for the comment Pietro. Whilst I obviously don't agree with Sumner's position, I do think it is worthwhile to engage in the constructive debate about why this is the case.
But I'm not sure he'd deny that there a real problems, it's mainly an argument about whether they're an inevitable consequence of the prior inflation or whether they're the result of policy failure. The correct answer to this is surely "both", in which case there's a very important debate about magnitude. And although, as we can see, base money does not always correspond to the total amount of credit available, would you argue that it's irrelevant?

Pietro M.

I don't like my previous comment, the tone looks too aggressive. I was probably in a hurry.

Base money is relevant when variations in its price and quantity can affect the credit/money multiplication process. So, yes, it can be relevant, but only marginally so.

At zero rates there is some margin to do something:

1. The rate is normally the overnight rate, term rates are low by arbitrage: affecting the cost and liquidity of term rates directly can increase the effectiveness of monetary policy when arbitrageurs (banks and non-bank financial institutions) are more risk averse, for whatever reason. This can't last forever, however, as term rates will sooner or later fall, too.

2. The increase in the Fed's balance sheet is used to monetized worthless private assets, and this has a direct net worth effect on financial firms' balance sheets (although it delays the recovery). It's recapitalization (or at least "reduced decapitalization") through monetary policy.

3. Interest on reserves may even help building up some additional revenue for banks. In the end, they gain a (probably very small) seignorage revenue which would have accrued to the central bank.

In other words, if the problem is real, Sumner's policies are inconclusive; if it is financial, there is a very small net worth effect in helping the financial sector, but the problem is not "monetary" in nature; if the problem is monetary, he is right, but I believe this hypothesis to be wrong.

Monetary adverse shocks are an endogenous accelerator of other problems, real or financial. A monetary crisis is part of the hangover: it is the result of real and financial distortions which are evident both in the weakness of balance sheets and in the inefficient allocation of labor and capital goods.

The issue is: is the problem real or financial (as it is unlikely it is monetary)?

If it is financial, restructuring the financial sector would create a boom in lending. Recapitalizations, regulatory forbearance, low interest rates, high liquidity, bailouts and removal of bad assets would have strongly procyclical consequences. They haven't, as far as I know. Maybe they haven't been tried strong enough.

There is a more likely explanation: there is nothing that can be done to resume a boom in these conditions because the real sector has problems. Finance is surely an additional problem. The money is scarce, on the other hand, I see no evidence.

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