Speculative markets are not black holes

Marc Faber is a very knowledgeable guy, but thumbing through a copy of his most recent Gloom, Boom, & Doom Report, I stumbled on a pretty big error. Here is Faber:

"All the liquidity that central banks have created isn't flowing into the real economy but remains in asset markets (mostly financial markets) buying and selling currencies, bonds, stocks, real estate, art, entire companies, etc. For example, most corporations find it advantageous to buy back their own shares (in order to boost their share prices) instead of investing in new plant and equipment... Or take wealthy individuals as another example. Most of them invest in stocks, bonds, funds or real estate; very few of them go out and build businesses. Private equity funds do the same: instead of building new businesses, they tend to buy existing assets." 

and later on:

"I believe that as long as savings and newly created fiat money flow into booming and speculative asset markets, real economic activity will remain depressed."

Faber is repeating a very old fallacy that goes something like this: new money and credit can stay tied up in financial markets indefinitely. This unproductive absorption of capital by speculators in turn prevents the real economy from benefiting. New buildings and factories go unbuilt, consumer goods go unsold, and cutting- edge technology goes undeveloped because the stock market 'sucks up' all the money.

Marc Faber styles himself as an Austrian economist, so he should know that Fritz Machlup, an Austrian 'fellow-traveller', dealt with this particular fallacy in his 1940 book The Stock Market, Credit and Capital Formation (pdf).

In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.

Here is the argument in more depth. Say that Frank (for lack of a better name) invests fresh money in a new issue of corporate shares. These funds don't fall into an abyss. Rather, the issuing company now owns them and uses them to build a factory. Faber would approve since machinery is being created from scratch.

But even if Frank uses the new money to buy already-issued shares rather than newly-issued shares, these funds don't get sucked into a vortex. They are now held by the seller of the used shares, Tom. And the moment Tom uses these funds to buy a car or invest in his home business, they are released into the real economy.

Of course, Tom might simply reinvest the funds earned on the sale in another stock or bond. But this changes nothing since an entirely new seller, Sally, comes into ownership of the funds. Like Tom, Sally might choose to invest it in real capital or on consumption, the real economy enjoying the benefits. Or she might choose to reinvest in the stock market, selling to Harry, and so on and so on. But even if the next ten or twenty recipients of Frank's newly-created money all choose to reinvest those funds in equities, the stock market is nothing akin to a black hole. At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good. Though the chain along which this money might travel can include many people along the way, when it finally exits only a few financial heartbeats will have passed.

So in sum, contra Faber money and credit cannot be held up inside speculative markets. It doesn't take long for it to be spent into the real economy.

For those who like to keep track of these things, the 'financial black hole' myth is related to the 'idle cash on the sidelines' myth, dealt with ably by John Hussman many years ago. In the 'sidelines' story, money sniffs its nose at the market and stays at the edge of the dance floor only to have a sudden change of heart, subsequently flooding the stock market. But as Hussman points out, when you put your cash on the sidelines to work in the stock market, it becomes someone else's cash on the sidelines. Both the black hole and sidelines stories are wrong because money doesn't disappear when it is spent. Rather, there is a seller who is left holding the stuff.

Richard Cantillon on Cantillon Effects

There's a dustup between market monetarists and Austrians over Cantillon effects. See Nick Rowe, Scott Sumner, Bill Woolsey, and Bob Murphy. What are Cantillon effects? One definition is the effect that a change in the money supply has on the real economy due to where money is injected. Rereading Cantillon, I think its better to define the effect he is writing about as the influence that a change in the money supply has given that people are incapable of anticipating that change.

Cantillon wrote in a world in which huge discoveries of gold in the Americas had steadily increased the price level. We know that if people perfectly anticipate the arrival of new gold, all prices will immediately rise. Cantillon thought somewhat differently. According to him, the initial discovery of gold would go unnoticed by people:

It is also usually the case that the increase or decrease of money in a state is not perceived because it comes into a state from foreign countries by such imperceptible means and proportions that it is impossible to know exactly the quantity which enters or leaves the state.

Il arrive aussi d'ordinaire qu'on ne s'apperçoit pas de l'augmentation ou de la diminution de l'argent effectif dans un Etat, parcequ'il s'écoule chez l'Etranger, ou qu'il est introduit dans l'Etat, par des voies & des proportions si insensibles, qu'il est impossible de savoir au juste la quantité qui entre dans l'Etat, ni celle qui en sort.

In his paper on Richard Cantillon, Michael Bordo echoes this:

In Cantillon’s work, the dynamic path of adjustment of relative prices, output, the interest rate, and specie flows depends on the expectations of agents in the various markets. This emphasis on expectations presages much of modern monetary theory. It is unclear exactly how expectations are formed in his scheme but the frequent examples of agents catching on slowly suggests that they are formed adaptively. Moreover, the repeated examples of people being fooled suggests that the availability and cost of information is an important aspect of Cantillon’s scheme. Such an emphasis antecedes modern macro theories of disequilibrium.

Cantillon then goes on to describe how unanticipated gold inflows would first be spent on food, forcing up food prices and the earnings of farmers. Farmers in turn employ more land, forcing up land prices. While all prices have now adjusted to the change in the money supply, during the adjustment period landowners are relatively disadvantaged since the price of their product is the last to increase.

While we don't have to agree with Cantillon's ordering of effects, it seems uncontroversial to assume that if expectations only adapt slowly, then there will be some sort of distributional effect during the adjustment period to an unanticipated change in the money supply. There can certainly be debate over the size and consistency of this effect. Austrians, for instance, build a business cycle theory out of it. Others consider the effect to be ephemeral.

On the other hand, if rational expectations are assumed from the start, then the location of gold's injection point is moot since everyone perfectly anticipates the repercussions and adjusts. In talking about injection points under rational expectations, it seems to me that market monetarists are having a totally different conversation than Austrians, who are interested in injection points under imperfect expectations. Is this just a debate over the nature of expectations? I see that Bryan Caplan has made the same point.

Questions for Bob Murphy and other Austrians on the inevitability of the bust

David Glasner had some recent posts (here and here) on Ludwig von Mises and Austrian Business Cycle Theory (ABCT). Bob Murphy pushed back here with a good rebuttal. But David's general point still stands: what necessarily forces a central bank that has adopted the practice of lending at a rate below the natural rate to ever cease this practice? Why does there have to be an inevitable bust?

I consider myself an Austrian in that one of my favorite economists is Carl Menger. I've also written a thing or two for the Mises Institute, my most recent being on Menger and Leon Walras and how the two would have differed on the phenomenon of high frequency trading. On the other hand, when it comes to macroeconomics, I remain a business cycle agnostic. I'm willing to be converted though. All you've got to do is answer a few questions of mine.

Say a central bank decides to reduce the rate at which it lends below the natural rate. Businesses can come to it for cheap loans -- and they do. Mises points out that as long as this differential exists it'll eventually lead to a "crack-up boom". The currency enters hyperinflation stage and, at its peak, people either turn to barter or dollarization occurs. Alarmed at this prospect, the central bank will probably increase rates in order to stave off the crack up.

But say the central bank and the currency users exists on a small island far from everywhere so dollarization can't happen. Say also that the police force is vigilant about preventing people from bartering. As a result, the currency issued by the central bank continues to be used, even during hyperinflation. The inevitable flight from money — the crack-up boom — can't occur. The currency perpetually falls.

So having assumed the crack-up boom away, why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.

So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?

To start off, one explanation for a bust occurring is that when rates are kept too low, excess resources are allocated to interest-sensitive distant projects and not enough to less interest-sensitive near-term projects. At some point there's a realization that not enough capital has been allocated to present needs and all those future projects suddenly collapse in value. Thus a bust. What causes this sudden epiphany? As David Glasner asks, are workers dying of starvation?  It can't be higher interest rates that render these projects unprofitable since, as I've already pointed out, the central bank keeps rates permanently low.

Even if capital begins to flow into projects that are only profitable at low rates, wouldn't the prices of materials required by those projects be bid up relative to other prices, thereby putting a quick end to the profitability of these distant projects? Wouldn't the relative prices of material required for near term projects fall, thereby increasing the profitability of near term projects? How can any significant capital misallocation proceed given these rapid relative price adjustments?

If you can answer all my questions, then you'll have successfully converted me.

Mises, Smith, and the origins of money

Lord Keynes continues to squabble with the Austrians on the origins of money in two separate posts, one on Adam Smith and the other on Mises's regression theorem.

The combativeness on the blog is unproductive, but I left a few comments anyways.

On Smith:

I don't really disagree with your claims, although I think you have to read the full Wealth of Nations in order to appreciate Adam Smith's theory of money. For instance, you are quoting from book 1 chapter 4, but Smith also has a very interesting (and much more extensive) chapter describing the complex workings of the system of bills of exchange, so he was by no means focused on gold and silver as money (See book 2 chapter 2). In this way he was different from Menger, who never discusses credit. Like Henry Dunning Macleod (who I see someone has already quoted), Smith was comfortable with credit as money.

 The existence of Henry Dunning Macleod, as well as George Berkeley and James Steuart, disconfirms the thesis that classical and neo-classical economists were uniformly metallists. All advocated to various degrees a credit theory of money. Jevons credits Macleod for laying the framework for marginal utility calculus, so he was surely neoclassical.

 The "origins of money" debate is interesting but I don't know how important it is. I think it's perfectly logical to adopt a Mengerian metallist approach and a Macleodean credit approach, modifying each just enough so that they can be amalgamated. Let the anthropologists take care of the chronological order of things.

On Mises:

But there is a severe flaw underlying Mises’s whole intellectual program in producing his Regression Theorem: the truth of the assumption that money only has indirect utility.... The view that money only has utility through its exchange value is also held by neoclassicals... This idea held by Austrians and neoclassicals should be rejected."

 I think you'll find that a number of Austrians already reject this. William Hutt's paper on the Yield from Money Held is a good example.

 http://mises.org/daily/3449

There are plenty of problems with Hoppe's article, but it is a good example of what I am talking about. Hutt was a fellow traveler of the Austrians and his paper is very popular in Austrian circles.

See an earlier post on Menger and the origins of money.