Tuesday, June 4, 2013

Greg Hill versus Steve Horwitz: A Keynesian–Austrian Debate

The Austrian Steve Horwitz and the Keynesian Greg Hill had a debate on the pages of Critical Review as follows:
Hill, Greg. 1996. “The Moral Economy: Keynes’s Critique of Capitalist Justice,” Critical Review 10: 411–434.

Horwitz, Steven. 1996. “Keynes on Capitalism: Reply to Hill,” Critical Review 10.3: 353–372.

Hill, Greg. 1996a. “Capitalism, Coordination, and Keynes: Rejoinder to Horwitz,” Critical Review 10: 373–387.

Horwitz, Steve. 1998. “Keynes and Capitalism One More Time: A Further Reply to Hill,” Critical Review 12: 95–111.

Hill, Greg. 1998. “An ultra-Keynesian Strikes Back: Rejoinder to Horwitz,” Critical Review 12: 113–126.
While I will not cover every detail of the debate, two important aspects of it were the issues of (1) the coordination of saving and investment, and (2) loanable funds theory.

Hill notes that, as Keynes argued, the decision not to spend one’s income today on goods or services does not entail that the money will be spent in the future on goods or services (Hill 1998: 114).

Horwitz appeals to a loanable funds model, in a rather idealised form, in his critique of Hill. Under the loanable funds theory, when people reduce consumption, the resulting savings add to loanable funds and this is supposed to lower interest rates and induce more capital investment in production of goods that will be available at some point in the future. The hidden assumption here is that an individual’s increased saving will necessarily increase total saving, for it is total saving that must be increased to reduce the rate of interest (Hill 1996a: 374). But even if we assume that the money saved by a potential consumer is made available for capital goods investments, the money not spent by the consumer reduces the income and savings of a business where he or she would have spend the money, and the income and savings of the business’s employees and suppliers. Therefore the addition to business savings and savings of those who earn income from the business will be prevented by loss of income from the first act of saving of the consumer, and the total amount of savings need not be higher (Hill 1998: 116). When such a process occurs throughout an economy, in the aggregate there need be no increase in saving, but reduction in demand deposits, and reduction in the broad money stock. Therefore the interest rate need not fall, and the supposed inducement of more investment will not happen. Thus an increase in current savings need produce “no inducement to expand future output in the absence of an order for future delivery” (Hill 1998: 115).

Austrians might claim that a lower interest rate – or a lower price of credit – will induce greater investment when interest rates fall, but this does not necessarily follow in a world where business faces uncertainty, where expectations are subjective, and where demand for investment credit can collapse or be stagnant.

And there is also a fundamental flaw in the whole loanable funds model: the fact that a great deal of what we call “saving” is spending of money on secondary real asset markets and, above all, on secondary financial asset markets. The decision not to spend money on consumption goods today does not mean the money is necessarily transferred to banks that finance capital goods investments. Often, especially in the case of the rich and very rich, the money is used to buy financial assets, and may be diverted to exchanges between buyers and sellers of such financial assets for significant periods of time. The purchase of a stock, bond, or financial instrument on a secondary financial asset market does not make that money available for capital goods investments per se; nor does it lower interest rates. In other words, there is a devastating flaw running through the whole loanable funds model: the assumption that money not spent is going to be simply put in a financial institution that lends the money for real investment.

The blogger MGM on the short-lived “Austrian Economics” blog expresses a crucial observation on this point:
“… savings find their way into the financial sector, because financial assets possess a great deal of liquidity. And depending on one’s appetite for risk, one can attempt to sacrifice a little liquidity for the possibility of capital gains (speculation); but because most financial assets have orderly markets, it is relatively easy to sell these assets for money. Capital goods, however, are not easily resalable (liquid).

For Post Keynesians, the financial sector is very different from the industrial sector. The financial sector deals principally with liquidity, and aims to provide people with liquidity (savers). The industrial sector, on the other hand, deals with real tangible (not easily substitutable) capital goods. These goods do not provide liquidity, because they cannot easily be sold. People who deal with capital goods must therefore look to its prospective yield and not its liquidity properties. These people are generally capitalists, and not savers.”
“The Horwitz and Hill Debate: Or, Why the Austrians are Wrong about Financial Markets,” Austrian Economics, March 27, 2011.
Moreover, the banking and monetary system is endogenous, which means that it generates new money in response to the demand for (1) credit or (2) demand deposit money. Hill is absolutely right to stress that modern banking systems create credit in excess of savings and prior monetary saving is not needed to back investment (Hill 1996a: 381). Assuming resources are available, new monetary saving is therefore not even necessary for increased credit creation and investment. In a world of vast international trade, industrial sectors with unused excess capacity, and idle resources, even at a high level of employment, capitalist systems can still provide elasticity of production of many goods without serious inflation.

But the demand for investment credit is still dependent on many things other than a crude supply and demand curve for money, such as expectations of future profit, the level of demand, sales volume, expectations of future sales and orders, and so on.

Horwitz also thinks that flexible wages and prices will prevent, or at least be the solution for, unemployment when saving exceeds investment. Here Hill notes that Horwitz misunderstands Keynesian theory, because Keynes in fact argued that, even if wages and prices were perfectly flexible, involuntary unemployment would exist (Hill 1996a: 377). The most devastating response Hill has to Horwitz’s flexible wages and prices model as the cure for unemployment is the disastrous debt deflation that results from wage and price reductions (Hill 1996a: 378).


Links
Robert Vienneau, “Steven Horwitz and Post Keynesians,” Thoughts on Economics, June 1, 2008.

“The Horwitz and Hill Debate: Or, Why the Austrians are Wrong about Financial Markets,” Austrian Economics, March 27, 2011.

Dan Kervick, “Do Banks Create Money from Thin Air?,” New Economic Perspectives, June 3, 2013.


BIBLIOGRAPHY
Hill, Greg. 1996. “The Moral Economy: Keynes’s Critique of Capitalist Justice,” Critical Review 10: 411–434.

Horwitz, Steven. 1996. “Keynes on Capitalism: Reply to Hill,” Critical Review 10.3: 353–372.

Hill, Greg. 1996a. “Capitalism, Coordination, and Keynes: Rejoinder to Horwitz,” Critical Review 10: 373–387.

Horwitz, Steve. 1998. “Keynes and Capitalism One More Time: A Further Reply to Hill,” Critical Review 12: 95–111.

Hill, Greg. 1998. “An ultra-Keynesian Strikes Back: Rejoinder to Horwitz,” Critical Review 12: 113–126.

21 comments:

  1. Horwitz is a supporter of free banking and I think by omitting that detail from your post you are seriously distorting his argument.

    I think he would accept that in the current central bank regime there is no guarantee that the interest rate will equilibrate planned savings and planned investment. An increase in desired savings combined with the empirically observed fact of sticky wages will likely result in a recession. This is because a central bank monetary regime is unable to maintain monetary equilibrium.

    His point is that under a free banking regime the market would create processes that would address this. Free banks , able to issue their own currency , would be able to expand the money supply in the face of the increased demand for money that drives the increased planned savings. This would have the effect (stated a bit simplistically) of stabilizing AD.

    By ignoring the free banking angle in your post you end up just attacking a straw man and not Horwitz's real views.



    ReplyDelete
    Replies
    1. (1) I am well aware that Horwitz is a free banker.

      Hill in fact also knows that and provides a thorough critique of Horwitz's free banking model.

      (2) I disagree that a free banking regime would be able to "maintain monetary equilibrium." To maintain AD, investment spending, above all, must be maintained. But in depressions/recessions that is precisely when demand for investment credit from capitalists collapses, owing to poor expectations and uncertainty. No amount of "new currency" issued by free banks will properly induce the necessary level of investment -- just as in the US we see the failure of QE1, QE2, and QE3.

      Credit money creation is demand driven. The demand for credit is largely a function of aggregate demand (AD). You need fiscal stimulus if you want a relatively effective and fast way of expanding AD.

      Delete
    2. I didn't read the Hill articles but the way you presented Horwitz's views made him sound like a Rothbardian who thinks that flexible prices will always lead to the loanable funds and labor markets clearing.

      This is a serious misinterpretation of his views.

      (If you think that I is fixed and the only solution is to increase G then obviously you will think that increasing M is not going to help - lets not have that discussion again !)

      Delete
    3. "Credit money creation is demand driven. The demand for credit is largely a function of aggregate demand (AD)."

      Actually this seems somewhat consistent with the free banking model. The money supply will endogenously adjust to changes in demand and monetary equilibrium will be maintained. In this equilibrium aggregate demand will be sufficient to optimize output and employment. No need for fiscal stimulus.

      Delete
    4. "The money supply will endogenously adjust to changes in demand and monetary equilibrium will be maintained. "

      If that is all "monetary equilibrium" is supposed to do and not prevent collapse of AD, then you've effectively conceded my argument.

      Delete
  2. " An increase in desired savings combined with the empirically observed fact of sticky wages will likely result in a recession. "

    (1) And why wouldn't wages and prices be sticky in a free banking regime too?

    (2) Also, downwardly flexible wages and prices isn't the solution. It just causes debt deflation.

    ReplyDelete
    Replies
    1. The whole point is that if the money supply is flexible then wages do not need to be.

      An increased demand for money will lead to decreased AD in nominal terms. If wages are inflexible then the money supply needs to be if unemployment is to be avoided. If you increase the money supply enough to keep its value constant then you maintain monetary equilibrium - in simplistic terms you keep AD constant even while the demand to hold money is increasing.

      Delete
    2. Rob,

      But who is going to provide more money to hold? I don't think that what you mean by the 'money supply' accurately corresponds with the real world, because in the real world money is provided by the banks and there is no single decision that sets the supply of money. If there is a recession, the banks are going to provide less money, because less firms will demand credit from them. I.e. the money supply is flexible alright, but in the wrong direction. I could hardly see how the existence or absence of a CB will change this situation.

      Delete
    3. A possible free banking scenario envisages private currency issuers committing to maintaining a stable value for their currencies.

      This will partially be acheived by fractional reserve banking which has an incentive to expand the money supply as demand to hold increases. If banks will not (or cannot) lend then the currency issuer would buy and sell assets to maintain the currencies value.

      Delete
    4. "A possible free banking scenario envisages private currency issuers committing to maintaining a stable value for their currencies. "

      How? If the demand for credit money collapses and deflation sets in?

      "This will partially be acheived by fractional reserve banking which has an incentive to expand the money supply as demand to hold increases"

      But demand for credit money decreases or collapses during recessions/depressions. How will free banks expand the money supply?

      "If banks will not (or cannot) lend then the currency issuer would buy and sell assets to maintain the currencies value"

      What currency issuer? You're saying that free banks are going to create their own fiat money and buy up private sector assets?

      So that instead of one central bank, you have hundreds of quasi-central banks creating money?

      And what's to stop them from causing asset bubbles and (according to Austrian theory) endless Austrian business cycles?

      Delete
  3. Indeed: I envisage competing currencies (not hundred's but a few) ready to supply money-services to the market in the same way that telephone companies supply telephony to the market.

    They would make their currencies attractive to potential customers by (perhaps) saying "we guarantee that our currency will always be fixed in value against a given bundle of goods". They would then trade their currency against other goods to make this happen. Obviously they would need sufficient capital to make this guarantee credible (BTW: as a supporter of fix-price models you would logically not see this as hard to implement).

    These private currencies would then be used as the basis for fractional-reserve banking. Under normal risk conditions FRBs will always match the supply and demand for money by adjusting the money supply and the interest rate. This will maintain monetary equilibrium with no need for the currency issuers to do anything.

    In some situations (like now) risk is high and banks will want to maintain high cash balances just as the demand for loans is depressed. This might drive interest rates to zero.

    In this case the currency issuers will need to buy assets to stop their currencies from appreciating. This will increase the money supply, increase AD and prevent the economy falling towards recession (and address the risk issue).

    ReplyDelete
    Replies
    1. So you think free banks would be issuing various competing fiat money?

      Logically, these "currency issuers" cannot be using scarce commodity money, since they simply could not just produce such money from nothing in response to demand for it.

      "In this case the currency issuers will need to buy assets to stop their currencies from appreciating. "

      But that would not necessarily increase AD at all. People may just hoard the money.

      Delete
    2. 'Logically, these "currency issuers" cannot be using scarce commodity money'

      Agreed, the example of bitcoin shows that commodities may not be a prerequisite for a stable currency. However if this turns out to be not true there is no shortage of assets that can be used to back private money.

      "but that would not necessarily increase AD at all. People may just hoard the money."

      If that were true then the private currency issuers could buy up every asset on the planet while people hoarded their currency units. This does not seem a very likely scenario.

      Delete
    3. "If that were true then the private currency issuers could buy up every asset on the planet while people hoarded their currency units"

      No, it might mean people just start to refuse to sell their assets to free banks.

      Delete
    4. So the price of everything goes to infinity ? I don't think I follow your logic.

      If that did happen I would also become a post-Keynesian at that point.

      Delete
  4. "And what's to stop them from causing asset bubbles and (according to Austrian theory) endless Austrian business cycles?"

    The fact that private currency issuers have committed to maintain their currencies value would prevent them generating artificial booms. I agree that some work needs to be done on the relationship between monetary equilibrium and asset prices as the demand for money (and AD) changes but I am optimistic that when done this will reveal a stable relationship.

    ReplyDelete
    Replies
    1. So you are saying there would be no regulation of credit flows to speculators by free banks, who could grant credit to whomever they please, but somehow there would never be any asset bubbles?

      Delete
    2. Well, most recent asset bubbles would not have taken place in my opinion without FDIC and other implicit and explicit government underwriting of risky investments.

      If people stood a real risk of losing money when they lent it to a bank they would choose banks that made sound investments.

      Delete
  5. Lord Keynes,

    Thanks for the post and the opportunity to review this debate from my point of view.

    I have two questions for the advocates of “free banking.” Is a “run on the banks” impossible under free banking? If not, how is such a run brought to a halt before it devastates other sectors of the economy? Federal deposit insurance and the central bank’s lender of last resort function seem to have pretty good record in this respect, no? I guess that’s actually three questions.

    ReplyDelete
    Replies
    1. Greg,

      "Is a “run on the banks” impossible under free banking? If not, how is such a run brought to a halt before it devastates other sectors of the economy?"

      That's exactly the question they never properly answer!

      Some might say that the free banks have "suspension" clauses in the contract you sign, which means that they can just refuse to pay you for some period of time to stop runs. But even that would impose severe strains on a capitalist system. Imagine not being about to access your money for weeks or months on end!

      Thanks for this comment.

      Delete
    2. It was a great debate, by the way! I might look more closely at the individual articles in the future.

      Delete