[jmherbener]

The proper distinction is between business fluctuations and business cycles.

Business fluctuations are caused by the normal changing of the pattern of consumer demands. The distinguishing characteristic of such fluctuations is that increases in demands for some goods must be counterbalanced by decreased demands for other goods. Changes in production that meet these changing demands earn profit and those that fail to meet them suffer losses. The additional resources needed to meet the increasing demands are balanced by resources being released where demands are falling. Entrepreneurial error can lead to mis-allocation of resources or mal-investments of capital funding, but these suffer losses and destroy equity and therefore, are not self re-enforcing. That is, other entrepreneurs do not make the same errors and those who have made mistakes correct them.

Business cycles are generated by monetary inflation and credit expansion. The additional money permits demands to increase for goods purchased with borrowed money without decreasing demand for goods bought without borrowed money. The distinguishing characteristic of business cycles is the clustering of entrepreneurial errors. Most auto companies mal-invest in their capital capacity during the boom. Most construction companies do the same. Because the changes in the pattern of demands are artificially induced by monetary inflation and credit expansion, they prove to be unsustainable. The proportion of their income that people prefer to save and invest is smaller than that made possible by credit expansion. But the build up of the capital structure during the boom is based on the greater apparent saving and investing made possible by credit expansion.

Asset price bubbles are a secondary feature of the boom and bust. Journalists focus on them because they are sensational and they can’t understand or think that their readers can’t understand the primary feature of the boom and bust. One problem of this focus is highlighted by your question: Can’t every instance of entrepreneurial mal-investment be interpreted, in retrospect, as an asset price bubble? If so, then the distinction between business fluctuations and business cycles is unnecessarily blurred.

[jmherbener]

There was dis-inflation, but not deflation. Here are more data:

http://www.census.gov/prod/1/gen/95statab/prices.pdf

[jmherbener]

The Fed tripled the monetary base:

http://research.stlouisfed.org/fred2/series/BASE?cid=124

It did this by buying securities from banks. Banks, in turn, have held most of this additional monetary base as reserves:

http://research.stlouisfed.org/fred2/series/ADJRES?cid=123

Most of this increase in reserves is nothing more than checking account balances that banks hold at the Federal Reserve.

As a consequence of most of the increase in the monetary base being held by banks as reserves, the money stock has increased relatively modestly:

http://research.stlouisfed.org/fred2/series/MZM?cid=30

Even this increase in the money stock has not generated much price inflation, because the demand to hold money increased in the wake of the financial crisis:

http://www.bloomberg.com/news/2013-03-08/offshore-cash-hoard-expands-by-183-billion-at-companies.html

None of these monetary shenanigans by the Fed has averted recession:

http://www.bloomberg.com/news/2012-04-02/five-years-after-crisis-no-normal-recovery.html

[jmherbener]

Here is a conventional, economic history of WWII:

http://eh.net/encyclopedia/article/tassava.WWII

It stresses micro-economic analysis instead of macro. Take a look at the citations for more sources.

[jmherbener]

Interest rates are not determined by supply conditions alone, but by demand and supply. Demand for credit has collapsed in the wake of the over-indebtedness of the boom. Both consumers and entrepreneurs are paying down debt.

(As an aside, the same analysis applies to price inflation. The purchasing power of money is determined by both the demand to hold money and the money stock, not the money stock alone. Thus, even though the money stock has been increasing, there has been little price inflation because people’s demand to hold money has increased, as it typically does in a downturn.)

Furthermore, “money printing” by the central bank does not mechanistically expand the supply of credit. The Fed has purchased around $1 trillion of assets from banks and paid with newly issued base money. But, banks must decide to issue fiduciary media on top of theses reserves to expand credit. They haven’t been doing this. Instead, they are holding the additional base money created by the Fed as excess reserves to shore up their balance sheets.

In normal times, the Fed influences market interest rates by stimulating banks to produce credit expansion. Lowering the discount rate can be a technique to do this, but the main method it uses is buying assets from banks. With the larger reserves, the banks then expand the supply of credit by issuing fiduciary media. The increased supply of credit lowers interest rates.

Interest rates will rise to normal levels when the demand side of the time market returns to normal. Normalcy will return when the pay down of debt is complete and the conditions for investment improve.

[jmherbener]

Foreigners can either hold the dollars overseas or spend them back in the U.S. If spent in the U.S., foreigners can either buy goods and services or make financial investments. As you say, the balance of payments accounts record the consequences of theses actions and are designed to always balance.

Of all the dollar currency in circulation, approximately two-thirds is held by foreigners overseas. They do this for buying goods which are bought and sold in dollars, as you suggest, and as a safe-haven asset.

http://www.federalreserve.gov/pubs/ifdp/2012/1058/ifdp1058.pdf

A given money, like the dollar, moves from one place to another based on differences in its market value, i.e., its purchasing power. If the purchasing power of the dollar were lower in New York City than in Denver, people would shift their demands to Denver until no difference remained. If the purchasing power of the dollar were lower in New York City than in Paris, people would shift their demands to Paris. To do so, they would sell dollars to buy Euros pushing the exchange rate of the dollar down until its purchasing power was the same in both places. The balance of payments accounts simply record the results of people’s actions which are determined by their preferences.

[jmherbener]

If U.S. Treasuries were downgraded, then interest rates would rise, or be higher than otherwise, on U.S. Treasuries. Because the rise of rates on Treasuries would be compensation for the greater risk of holding Treasuries, it would not necessarily lead to arbitraging into other bonds and higher rates for them. There were no wide-spread ill effects on bond markets from the Standard and Poor’s downgrade of Treasuries from AAA to AA+ in August 2011.

For banks that held Treasuries, if the downgrade raised their rates it would evaporate bank equity. Whether or not it made them insolvent would depend on the extent of their Treasuries holdings and equity. Even if it made banks insolvent, the Fed would probably intervene to keep them in operation.

I don’t see that it would have an effect on the dollar, unless investors thought that the federal government would rely more heavily on monetary inflation in the future to finance its expenditures.

[jmherbener]

1. There is doubt because the Fed can invoke policy to eliminate the potential for fiduciary issue. The most obvious case would be to raise the required reserve ratio to convert excess reserves into required reserves.

2. If investors see gold as a hedge against price inflation, then a dollar collapse is bullish for gold. Rising interest rates, under your scenario, are necessary to compensate for price inflation. The higher rates, then, do not imply higher real returns and thus, are not bearish for gold.

[jmherbener]

But most disputes today in our system are handled in private arbitration. For help in answering your questions, I suggest you read Bruce Benson’s book, The Enterprise of Law (Pacific Research Institute, 1990).

[jmherbener]

I suggest you re-post your comments and question on the “General Discussion” forum. You’re likely to get more discussion there than you will on this forum, which is dedicated to economics.

Having said that, I will venture a few comments. Economic theory demonstrates that the market economy arranges production in the manner that most fully satisfies people’s preferences. For the market economy to be sustained, private property and voluntary contract must be given the sanction of law and people must accept the legitimacy of private property and voluntary contract. Given that people prefer to have legal sanction of private property and contract, it doesn’t seem implausible that the services of adjudicating and executing those legal sanction could be done by private enterprise instead of by a state enterprise. If people don’t prefer to have legal sanction of private property and contract, then injustice will reign regardless of how the adjudication and execution of legal sanctions is organized.

[jmherbener]

The argument of your Keynesian friend is illogical. He is saying that the volatility in the dollar price of gold, which is not money, is due to the vagaries of the valuation people make of gold but not the value they make of the dollar, which is money. But if the value of money cannot be the source of the volatility of the prices of goods, then in a gold standard, i.e., when gold coins are money, the valuation of gold coins cannot be the source of volatility in the prices of goods either.

As to the “prediction” that the Fed’s expansionary monetary policy in the wake of the crisis would cause price inflation, the jury is still out. The Austrian theory of money explains that the purchasing power of money is determined by the Total Stock of money and the Total Demand to hold money, just as the price of any other good is determined. The money stock in our economy is money proper (i.e., Federal Reserve Notes printed by the Fed) plus money substitutes (i.e., on demand, at par redemption claims for money proper) issued by banks and other financial institutions. In the wake of the crisis, the Fed bought assets from banks and paid with reserves (cash and demand deposits at the Fed). In normal times, the banks would issue a multiple of fiduciary media on top of their reserves. But instead, banks have held excess reserves. Thus, the money stock has not expanded as some anticipated it might. Moreover, the demand for money has increased, as it often does during a downturn. This has moderated the reduction of money’s purchasing power. The jury is still out on whether the potential for monetary inflation in the form of excess reserves in the banks and a reduction of money demand will yet result in a significant monetary inflation when economic normality returns. That it hasn’t happened yet may be a strike against the historical acumen of those who predicted it would, but it doesn’t bear at all on the efficacy of the theory of money held by Austrians.

Finally, the claim that the economy cannot reach its highest production potential without continuous monetary inflation, which cannot occur under the gold standard, is both theoretically dubious and historically false. The fastest sustained period of economic growth in American history was during the latter part of the 19th century under the classic gold standard. The basic theoretical problem with this claim is that production depends not on prices of output, but on the spread between output prices and input prices. Such price spreads depend not at all on total spending in the economy.

[jmherbener]

If foreign demand to hold dollars collapses, then the foreign exchange value of the dollar will fall, which will prompt a repatriation of the dollar resulting in price inflation in America. But this scenario has nothing to do, per se, with U.S. trade deficits, foreign Treasury holdings, and so on. Accounts such as these result from people acting on their preferences. If their preferences change, then the patterns of exchange and production change, which then change the accounts. If their preferences do not change, then the pattern of exchange and production do not change and the accounts do not change.

Foreigners prefer to sell us more goods than we sell them and to buy from us dollars. They want to hold additional dollars and until that preference changes, the dollar’s exchange value will not collapse, no matter what the size of our trade deficit. If our trade deficit grows it means that foreigners want to hold additional dollars. Here is a story about the significant increase in foreign holding of dollars since the crisis:

http://www.federalreserve.gov/pubs/ifdp/2012/1058/ifdp1058.pdf

What checked profligate monetary inflation and deficit spending under the classical gold standard was the redemption of each currency at a fixed rate for gold. When people called into question the fixed rate of redemption of a currency for gold (e.g., after a government inflated its currency), this led to adverse trade flows, devaluations, and so on.

When the U.S. runs a trade deficit with China, the dollars the Chinese do not desire to hold they use to make financial investments in the U.S. Markets bring people with different preferences into mutually advantageous relationships. Americans save little and consume lots. Chinese save lots and consume little. When we come together in a market economy, the Chinese will produce more goods for us than we do for them and they will invest more in America than we invest in China. That’s what both groups of people want to happen. Our trade deficit is balanced by our capital inflow and China’s trade surplus is balanced by their capital outflow. These trade accounts are sustainable because they reflect people’s preferences. There is no problem here until the government crowds out Chinese investment in American private enterprise with Treasuries. That’s where the problems originate, not in imbalances in trade accounts.

[jmherbener]

A standard work discussing the different views on macroeconomics is Brian Snowdon and Howard Vane, Modern Macroeconomics: Its Origins, Development, and Current State (Edward Elgar, 2005). Here is a short review of the book:

http://mises.org/journals/qjae/pdf/qjae9_1_6.pdf

[jmherbener]

Efficient allocation of resources means that they are being used to produce goods that satisfy people’s highest-valued ends in the least-cost manner. It is not efficient to merely produce more stuff.

During the boom, monetary inflation and credit expansion results in a pattern of demands for goods and resources that results in the build up of the capital structure that proves to be unsustainable. Once the pattern of demands for goods and resources change in the crisis the efficient thing to do is to re-allocate the mis-allocated resources and mal-invested capital structure into those lines of production that best satisfy people’s preferences. For example, once the housing boom is over and demand for housing and the resources to produce housing throughout the capital structure have collapsed, the efficient thing to do is for some construction workers to find jobs elsewhere, some factories producing roofing shingles to be re-configured to produce other materials, and so on. Having build too many houses in Vegas during the boom, it is not efficient to use the resources to produce too many houses in Reno. If Keynesians are really against unemployment and excess capacity, they should favor eliminating all government impediments to the re-allocation of labor and capital goods.

[jmherbener]

Your points are well taken, but they require thinking about the problem of wage setting in the markets of the real economy. New Keynesians think about the problem within their models. The models are specified to generate sub-optimal equilibria under sticky-wage assumptions. The justification they give for this method is that the phenomenon of an “under performing” economy is experienced in the real world. If their explanation seems fishy to you, then go to the head of the class.

On the reasons for sticky wages in the real world, take a look at Joe Salerno’s blog post:

http://bastiat.mises.org/2012/03/whose-afraid-of-sticky-prices/

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