[This review originally appeared in The Thought. I've revised it since then, mainly due to the editorial comments of Corey L. Thrasher.]
Microfoundations and Macroeconomics: An Austrian Perspective. Stephen Horwitz. Routledge, New York, 2000. xii, 276 pp. HC.
Something is lacking in Austrian economics. For a school of economic thinking that has been around since the late 19th century, this is surprising. It shouldn’t be missing too many major pieces. One would expect it to cover all the big, glamorous areas of economics from then to now. Surely, there would be little cracks scattered about, but the overall structure needs ramification.
However, Austrian economics suffered a huge setback in the 1930s, almost withering away until the 1970s when the revival started. At first, a few conferences and books, here and there. Later, even more books, articles, journals, and even more conferences. Here is not the place to cover the full story, except to say that now the branches are healthy, the fruit plentiful. The fruits include works on prices (e.g., Thomsen 1992), entrepreneurship, the firm (e.g., Sautet 2000), and, now, macroeconomics.
Stephen Horwitz's Microfoundations and Macroeconomics is one of the latest examples. In this short work, he plants macroeconomics – economics of whole economies, including their changes – firmly in Austrian microeconomics – economics at the level of individuals and firms. He grafts Austrian trade cycle theory – its explanation of business cycles – onto monetary disequilibrium theory, that peculiarly non-Austrian theory of shifts in money championed by Leland Yeager, Axel Liejonhufvud, and Robert Greenfield. (2) (More on this below.)
From this framework, he analyzes inflation and also deflation. (A number of Austrian economists either ignore or think of deflation as a nonproblem if not as desirable.) Finally, he illustrates how fractional reserve free banking fits into macroeconomics – mainly by showing how laissez faire in banking would avoid many of the pitfalls of regulated or central banking. In other words, he focuses on how changes in money affect capital at a macroeconomic level.
Of Prices and Plans
The first chapter is a historical overview of the Austrian view of prices and market order. Horwitz claims market prices serve three functions: ex ante, ex post, and discovery. The ex ante function is to help decide which plans to pursue – this applies to the entrepreneur running a business as well as the shopper picking up groceries. Both want to make the best of what they have. Prices help them to decide how to use their resources. The ex post function measures plans actually worked. Was the business plan profitable? Did the product go to market at a price above cost? Did the shopper have enough money to buy a good dinner?
The discovery process is more dynamic than these two. It allows people to find new opportunities where they would not have planned. He uses the analogy of someone looking for a friend's number in a phone book – a deliberate plan like the ex ante function above – versus finding another friend who one didn't know recently moved into town in that same phone book – a true discovery. The former is a way of finding out what you know you don't know, the latter an example of discovering what you didn't know you didn't know. The latter sort of ignorance Israel Kirzner's dubbed "sheer ignorance." (Kirzner 1992, 22) The entrepreneur's essence is the ability to overcome sheer ignorance – to be alert to opportunities that wouldn't be seen in a business plan or that would, after being found, become part of one.
All of this sits in the context of economic actors – consumers, producers, and entrepreneurs – who have imperfect information. Prices reflect this imperfection. They are never perfect signals. This constrains their use and how well people can plan. Horwitz cites Estaben Thomsen's (1992) view of prices as knowledge surrogates, who expands on the work of Hayek. (1945) To all of them, prices are knowledge substitutes. One does not need, e.g., to know why the price of soap has gone up. Are the resources used to make it are more expensive? Or are more people are buying more of it because it's become fashionable to wash hands more often? One just sees the price rise and adapts one's plans to it, whether one shops for soap to use in the home or, say, buys it to supply a factory. Prices act in lieu of more complete knowledge, allowing people to act quickly without fully knowing or needing to fully know what's going on. This is very important in the real world, where one cannot take the time to examine each change before acting on it. Such time would, in most cases, be wasted as the situation would change again making for missed opportunities for those who fail to act.
Relative, not absolute, prices matter here. It's not so much that a bar of soap has a specific price in dollars and cents, but how that matches up with other prices. A particular bar of soap from a particular shop might cost more than another from the same shop or the same one from a different shop. It might also cost more or less than substitutes. Money spent on that bar can't be spent on other things – affecting other prices.
Horwitz is building up to something else, of course. These observations are not macroeconomics. They are part of the microeconomic foundations. After elaborating a theory of capital, he discusses money in the whole economy, since prices are always in terms of money. This is the macroeconomic payoff of this microeconomic theory investment. Anything that affects money in total – e.g., the Federal Reserve Board – will affect this knowledge surrogate function of prices. Things that hamper – inflation, deflation, price controls, and other regulations – this function will make it harder for people to plan, respond correctly to changes, measure success or failure, and to find new opportunities. Prices will be distorted, making it easier to make bad plans and harder to adapt as the process goes on, making for more waste and inefficiency than if the market interventions didn't happen in the first place. This impacts the whole economy in ways that will be discussed after looking at his capital theory.
Capital as a Structure
Chapter two, "The missing link: capital theory as microfoundations," completes the first part of the book. It starts with a brief historical survey of capital theory from the classical economists (especially David Ricardo) to modern Austrians. This condenses around a century and a half of economic theorizing to about twenty pages. Not surprisingly, he spends a section criticiquing John Maynard Keynes' view of capital theory – or lack thereof. Horwitz relies on Ludwig Lachmann, author of Capital and Its Structure, here.
What is capital? It's simply goods used to make other goods and services. Borrowing Bohm-Bawerk's terminology, think of goods as first order or higher order. First order goods are meant for consumption. A bar of soap, for most people, is a first order good. A higher order – second order, third order, etc. – good makes lower order goods. A bar of soap for an hotelier is a higher order good. She does not consume it, but uses it to satisfy consumer – here, her guests' – wants.
This might seem puzzling. After all, the bar of soap in a hotel might be the same one someone else uses in his home. In former case, it's a higher order good, while in the latter it's a first order good. What matters here is not the physical trait of the good, but where it fits in a plan. If it is used as a consumer good, then it is a consumer good. Hotels don't sell soap. They sell time a room with certain services. The soap for a hotel facilitates delivery of those services. Another example might help. A soccer mom driving a Ford Expedition is using it as a consumer good. An independent contractor who uses it to haul his tools and supplies from job to job is using the same truck as capital.
Other points to note from this plan-centric view of capital is that capital is not homogeneous and that it can be measured in terms of how well it fits together to result in a finished product or service. This is what Lachmann meant by seeing capital as a structure, rather than a stock. (1978, 2) The problem with most non-Austrian views of capital is they tend to lump it all together as if one can just inject a blob of undifferentiated capital into a production process. Soap and trucks, as you can see, are not equivalent and fit into different parts of a plan, if not different plans all together.
Two points to notice here about capital heterogeneity are the relationships different capital goods have to each other. The two basic relationships, again relying on Lachmann, are complementarity and substitution. Complementary goods work together, for better or worse, in a plan. The bathrooms and the soap in a hotel work together toward the finished product. They fit into that plan pretty well, most of the time. (Such a fit is not always something we can get beforehand. This is where entrepreneurship comes in, trying to find capital and labor that will work together to satisfy some expected want in a profitable fashion. The soap, e.g., might be the kind the hotelier later finds most of her guests don’t like or is much too expensive. That would be an example of a bad fit.)
Substitution holds when one good can replace another in a plan – when a different constellation of goods can create the same product or when one piece is replaced because of wear and tear or even because of some other change. An example of the latter could be a more durable engine in a truck might prompt the contractor to buy a new truck. While complementary goods work together, substitutes compete against each other. The former are both/and, the latter either/or. (Cf. Lewin 1999, 121-3)
Capital can also be seen in terms of first line, second line, and reserve assets. This distinction, again, comes from Lachmann. First line assets are those used in immediate production. Second line assets are those expected to be used later in the process. For instance, the hotelier might keep a stock of soap that she knows she will use over the course of a year. Reserve assets are rainy day assets. They are to be used if some aspect of the plan fails. Reserve assets often include money, though one must pay attention to whether the money is earmarked as a second line asset, such as money for payroll during a production process, or for unpredictable, but possible problems, such as money to pay for replacing equipment or workers. (Again, if one plans that a certain piece of equipment will fail during the process, this is a not a reserve asset. The same applies to expecting a certain amount of turnover in employees during a process.)
It should be noted that what is a first line, second line, or reserve asset depends on the plan. For instance, one hotelier might decide his guests should not get soap unless they ask for it. Soap that the other hotelier normally would have used as a first line asset – put out for each new guest – now becomes a second line or even a reserve asset, depending on expected usage.
Money does not directly produce here, but acts as a capital good by proxy – it can be used to purchase other goods needed in any plan. In this sense, money can be used as both a second line and a reserve asset. For example, a small hotel might have money on hand to buy supplies such as soap as needed rather than having a large inventory of these. A large hotel chain might be self-insured, having cash on hand for unforeseen problems such as damages due to severe weather, fires, and the like.
Horwitz castigates Keynes for viewing capital as homogeneous and not seeing this structure of production. The latter's view of capital is solely from the viewpoint of aggregation – of summing up all of it in a total economy. This is a flawed way to reckon capital, especially given that one capital good can compete with another, making it hard to lump them together. How are the values of the two competing goods to be added to form a meaningful total? What would that total signify? On top of this, changes in other parts of the economy can make a given capital good or set thereof more or less valuable. Capital goods used to make horseshoes are far less valuable now than they were one hundred years ago.
Another problem with the Keynesian view stems from this. For Keynes, there is no such thing as malinvestment. Since capital is a blob, any capital is as good as any other. This complete and perfect substitution of capital in his theory does not match the real world. Entrepreneurs do not always get it right. A plant used to make a given good might not be useful for anything else. Thus, if the goods it makes are not profitable or become more easily made by some other plant or process, the investment was a bad one. If no one wants horseshoes, then a plant that can only make horseshoes is a malinvestment. You just can't add any capital to any other capital and insure a profit.
Nor does a malinvestment need to be total. A capital good can often be used to make more than one item or service, but often, if it has to be used in another process, less profitably. Sometimes it is more, but often it is less valuable in another role. There are also the costs of retooling and even retraining workers to use capital in a different manner than originally intended. This is yet another example of the real world inhomogeneity of capital.
Money
Chapter three introduces Horwitz's paradigm for treating monetary issues: monetary equilibrium theory. He develops this from the capital theory he expounded in the previous chapter. "Equilibrium" might seem to be the wrong term for an Austrian economic theory, macroeconomic or not. After all, the hallmark of Austrian economics is that existing economies are never in equilibrium. Also, there's a tendency to avoid equilibrium analysis in Austrian economics? Why? It’s because the problems of economics – profits and losses, the need to coordinate plans, etc. – do not exist at equilibrium.
Nevertheless, monetary equilibrium is not about the economy as a whole being in equilibrium but about money supply being responsive to changes in the demand for money. (No doubt, diehard disequilibrium types will bristle at the claim. It will be interesting to hear their criticisms.) Another way of looking at this is that the amount of money matches the demand for it. Why would this matter? Since money is traded in every market in a money economy, it impacts the whole economy. Money is half of every sale with the exception of barters, which in a modern economy are rare. Money is the underlying means of coordination. Any change in money, therefore, has an effect on all trade. It will impact the previously mentioned functions of money – ex ante, ex post, and discovery – and this will affect capital structure. Before going on, let's look at how he contrasts his view with Classicism, monetarism, Keynesianism, and the New Classical Economics.
Classicism assumes money is just there and can be ignored in economic analysis: money economies are, essentially, equivalent to barter economies. Inflation or deflation according to this view would eventually work itself out because any increase in the money supply does not increase actual goods and services. This overlooks the fact that money economies are not just barter economies with one extra good – money – added. Money changes the whole nature of an economy by making far higher levels of coordination possible. (Barterers have to rely on someone wanting exactly what they have to offer for in trade as well as that person also having exactly what they want.) One can't just consider a money economy to be, underneath, a barter economy.
Add to this that changes in the money supply through whatever means impact the economy along specific causal paths. For instance, if the government prints more money, this will first be used to spend on certain goods and not others, making prices for those rise first. This makes the relative prices of them higher compared with the rest of the economy, altering the relationships between prices overall. This continues as sellers of those goods spend the extra money on other things, perhaps increasing their plants that supply those goods. The effects ripple through the whole economy, but not instantaneously or along the same path. Instead, things happen over time and at each phase more discoordination will take place. Think of it as if someone attempts to walk with one shoe that has a higher heel than the other. After doing this for long enough, the person's musculature and skeleton will deform. Propping up the other heel will most likely not, certainly not immediately, undo the harm.
(Typically, governments do not print more money, but instead sell more bonds or bills and lower interest rates, though the result is much the same. Lower interest rates, e.g., affect certain parts of the economy first, usually the larger debtors and those who can renegotiate their debt cheaply – typically these are the government, large investors, and big corporations. This means they will reap the initial benefits and drive up prices for whatever they purchase first and the effect will flow through the economy in ways that are ex ante hard to predict. What is predictable is that the outcome will be significantly different than if there had been no lowering of interest rates. The relation between prices as well as the capital structure will both be distorted.)
Keynesianism has no capital theory per se, treating capital as homogeneous. It also has no real theory of economic coordination. The free market is assumed to be uncoordinated beyond a certain level and government is assumed to be the means for further, optimal coordination, whether this be in terms of promoting investment, reducing unemployment, stabilizing prices, or increasing consumption. No explanation is presented of why markets would be out of kilter. (Garrison 1992)
Monetarism fares much better, because it assumes there is a natural rate of interest which monetary disequilibria do not reflect, either when there's too much money (inflation) or too little (deflation). Yet monetarism focuses on labor instead of capital, which, Horwitz admits is not totally flawed, but this disregards an important component of monetary changes. That is, how the latter affect changes in the capital structure. He cites two reasons for this. One is that "increases in the money supply usually make their way into the market via commercial loans, which suggests that a focus on producers and the effects of such increases on the capital structure make the most sense." (93) The immediate impact of inflation is on the loan market and on investments, not labor.
The other is that business cycle theory is about explaining changes in capital structure because it "grew out the empirical observation that it was the production of higher order goods that most affected by depression." (93) This is more important to Horwitz's macroeconomics than to merely score another point against monetarism. After all, the meat of the book is how monetary disequilibria affect capital structure. However, sticking to this context, if most of the effects of monetary changes are experienced in capital, a view that focuses elsewhere is, at least, partly flawed.
New Classicism assumes equilibrium states always and everywhere. According to Horwitz, this was a reaction to monetarism from the late 1970s on. It melds rational expectations theory with general equilibrium theory. Rational expectations theory posits that economic actors will not make systemic errors in predicting the future. They might get it wrong sometimes, but, on the whole, they are aiming in the right direction. They rationally expect the outcome and change if they're wrong, never persisting too long in the wrong direction.
This leads to the notion that monetary changes will be adapted to given enough time and, in general, such changes will have no impact. Since New Classicism, too, lacks a genuine theory of capital, again the focus is on labor. Given this, if the money system should change, say, by inflating, eventually the labor markets will adjust and any more inflation, provided it is not too random, will be anticipated and adjusted to.
The problem here is that if everything is in equilibrium and if everything is anticipated, then there is no economic problem to solve. Frederic Sautet calls this a market theory problem. (Sautet 2001, 7-16) If New Classicism is right, there is nothing to explain. Inflation or deflation will be overcome simply given enough time. Since there's no capital structure and no real accounting of price structure, price level is all that is important and this aggregate view, very similar to Keynes, misses all the microeconomic discoordination caused by monetary changes. Despite some changes in New Classicism, this picture remains much the same: assuming away the causes of what is to be explained. If economic actors can adjust smoothly to all changes, even if with some delay, then cycles should not exist and inflation (or deflation) would have only mild short run effects. Hardly the stuff of slowdowns, panics, recession, and depressions. It's a theory that can't explain most of the real world.
Inflation and Deflation
In the next two chapters, Horwitz attacks the twin problems of inflation and deflation. Inflation, as one might guess, results when there’s money beyond what people demand. Horwitz goes over the typical costs of inflation, such as “shoe leather” and “menu” costs. (Cf. Horwitz forthcoming.) The former are the costs associated with having to have more cash on hand to deal with price increases. The latter with the impact of price increases, such as changing actual restaurant menus, re-labeling groceries, and changing labor contracts to account for inflation. There are not, however, the only costs of inflation.
One other cost is that of trying to figure out how the inflation will impact one. This can vary from just trying to guess how much more money a consumer will need for his next trip to the supermarket to a large firm hiring a team of financial consultants to help with estimating costs and profits. This adds unrecoverable costs into the mix. Effort and resources spent trying to figure out and deal with inflation are those that could have been used to satisfy other needs and wants. The financial consultants are wasted resources, in this context.
Add to this that inflation does not impact the economy evenly. While pundits may speak of the rate of inflation, this is a construct and a weighted average based on a few prices. The actual impact is much more pernicious. It’s not the average price level that truly reflects the effect of inflation. Instead, changes in relative prices are the marrow of it. These tend to be much more subtle and complex, leading economists to underestimate the true cost of inflation.
Let’s elaborate. Recall Horwitz’s capital theory is one where capital has a structure. Inflation changes that structure as the prices of certain capital goods change relative to others. The exact path of the changes is near impossible to predict beforehand as discussed above. The exact path depends on so many extraneous factors. Eventually, this will change the whole price structure.
For a given entrepreneur, this effect will vary depending on where she or he fits into the economy. Our hotelier from an earlier example might have to pay more for soap because resources used to make soap have been shifted into other areas because investors getting the first round of inflationary loans have, say, driven up the price of shipping raw materials used to make soap and other goods. She might have to eat into her cash reserves or change her whole business plan if the effect is large enough.
Deflation is when there’s less money than people demand. This, too, distorts the economy. Unlike inflation, it leads to a reduction in purchasing and, ultimately, to lowering some prices relative to others. Also, unlike inflation, deflation is not as widespread because it leads almost immediately to unemployment of both people and capital, which is much easier to recognize.
Deflation’s effect on capital is also different. It generally leads not to malinvestments but to underinvestment – to idle resources, excess inventories, and more missed opportunities. Horwitz likens inflation to forced savings and deflation to forced investment. This means that in either case, ex ante savings and investment are decoupled. In inflation, investment is higher than savings, while in deflation the opposite is the case. For instance, a market interest rate set higher than the natural rate would lead to less loans being made – and even to savings be more profitable than other uses of money.
This combines with “price stickiness.” What is meant by this term is that prices, in general, are usually downwardly rigid. People are less likely to lower prices immediately in a deflating economy. Eventually, as inventories grow and sales are not made, prices will come down, but the delay imposes costs. Again, because it’s nearly impossible to separate out deflation from other signals and the exact path of deflation is unpredictable for the most part. Trades that would have been made are forgone. Investments that could have yielded a profit are not made.
A specific example is a labor contract that stipulates a certain wage rate for, say, a three-year period. As the economy deflates, the firm signing onto that contract will have to cut costs elsewhere first, then most likely go through lengthy and costly negotiations to try to bring wages down. (Chances are, the workers might not see it as management trying to deal with deflation, but merely as the latter trying to get a larger share of the pie.) Resources wasted in this area cannot be used elsewhere. Thus, the costs of the deflation are irrecoverable.
As we can see, both inflation and deflation are necessary to avoid. Both make for maladjustment in plans and prices. They lead to unsustainable capital structures and to less overall wealth. Corrections are inevitable, but only after much wasted effort. Later in the book, Horwitz recommends what sort of money system would best avoid both problems. We shall return to this after considering his revival of the work of another economist.
Say's Law According to Hutt
Horwitz’s summary and appraisal of William H. Hutt’s work on price rigidities is another reason to recommend this book. Hutt's main focus is on the labor market and price changes in that market. This might seem out of place in a book that centers on capital theory and money, but this is Horwitz's attempt to bridge the gap between labor and capital, while still keeping his attention on the latter. Instead of focusing on where the two disagree, let's go over how Hutt's view fits into the framework of this book.
One of Hutt's goals was "to explain the widespread idleness of labor and capital associated with events like the Great Depression." (177) In other words, he was trying to theorize about the same macroeconomic problems Horwitz focuses on, though he comes up with a "non-monetary explanation" for these based on his understanding of the labor market and Say's Law.
Hutt distinguishes between different types of idleness in the labor market. Three basic types he notes are preferred idleness, pseudo-idleness, and price-driven idleness. Preferred idleness is when people want to be idle. A benign example is people who make enough money that they prefer to have weekends off. A less benign example that Horwitz points out is that of government unemployment insurance. (179) Obviously, having more benefits for being idle will increase the amount of preferred idleness. (Just as obvious should be the need to remove government unemployment insurance. This also does not consider the up front costs of unemployment insurance – higher taxes and other regulations.)
Pseudo-idleness is when "workers or assets that appear to be idle but are actually producing something." (179) Examples are people searching for jobs. Job-hunting is a form of productivity. If you find it hard to view it as such, think of it as activity aimed at achieving an increase in wealth. The job hunter wants to go from not having a job to having one, which, when achieved, is hoped to be a net gain. This makes it no different, at this level, than any other economic activity.
Price-driven idleness happens when wages or prices are coercively kept above market clearing levels. Minimum wage laws and price supports are obvious examples of such, though other policies – union laws (not unions per se, but laws that coercively favor unions), occupational licensing, and other legally erected barriers to entry – can also result in much the same thing. The systemic effects of such price mandated price rigidities go beyond just the supply and demand for labor in a specific industry via Say's Law.
Hutt thinks of Say’s Law as "the most fundamental 'economic law' in all economic theory." According to Horwitz, "Hutt uses Say's Law to get at the interconnections between the various sectors of the market." (180) How so? Say's Law, classically put, is "supply creates its own demand" or "there can be no general overproduction." His definition is more to the point: "the demand for any commodity is a function of the supply of noncompeting commodities." Put another way, people bring to market what they believe can be exchanged for what they want, either of which can be goods or services. (Note how this seems related to complementarity and substitution in capital.)
Armed with this view of Say's Law, it's easy to see that any enforced rigidity of prices or wages would lead to systemic problems, the more widespread and inflexible the rigidity, the more severe the problems. To elaborate, what would happen in the labor market is this. A given set of laborers produce goods and services so they can get other goods and services. By setting their price too high, less of their labor would be available, other things being equal. This is merely supply and demand applied to labor. An example is a minimum wage law. This prices less valuable workers – those whose labor is worth less than the legal minimum – out of the market, making them unemployed, even if they would take the lower wage. (There are also monitoring and policing costs associated with minimum wage laws.)
Given money, there is a delay in how quickly this effect can progress. Following Hayek, Horwitz calls this a "loose linkage." (85) Workers, or anyone for that matter, in a money economy, produce something then trade that for money and then trade the money for the other things they want. (In order for money to work well in this role, the linkage need not be tight, but monetary equilibrium must be maintained or approximated.) Enforced rigidities mean less of their goods or services would be on the market. With less overall wealth, there would be less to trade for – less for others to use their labor to get. This is how the effect of price controls, including those on the price of labor, deforms the whole economy. The remedy Hutt and Horwitz both endorse is obvious. In order to foster better economic coordination and more wealth creation, remove the price controls.
It's also important not to assume that the market as such is at a clearing level. Competition allows firms and workers to find out what the appropriate wages are. A firm that pays too little for its workers will lose workers to other firms. Workers who ask for too much will find themselves less employable, if not unemployed. The same is true for the opposite situations. A firm that pays too much will lose profits. A worker that asks for too little will find herself overemployed and see fit to ask for higher pay. This process is self-correcting, but only if price controls do not disrupt the corrections. (191)
Recommendations
The rest of the book is a sort of cashing in the value of the earlier insights in terms of their policy pay offs. What policy recommendations spring from an Austrian macroeconomics? How would it be any different than earlier recommendations of Austrian theorists such as von Mises, Hayek, Rothbard, and those of non-Austrians?
First he distinguishes between monetary policies and monetary regimes. Policies are recommendations for central bankers on how to run the money system, e.g., what inflation targets to hit or what level of unemployment to allow. Regimes are the institutional setup of the money system. It is really the latter that Horwitz wants to change.
Like many Austrians, Horwitz advocates laissez faire in the money system, specifically a free market in banking, from note issue to interest rate setting to all the other services banks deliver. He differs from some Austrians – notably Murray N. Rothbard – in that he believes a fractional reserve system will best deliver this.
To this end, he compares a fractional reserve free banking regime to central banking as well as to full reserve and the Black-Fama-Hall (BFH) regimes. In the end, he recommends free banking over the others because theoretically and historically it's a better guarantor of monetary equilibrium.
His criticisms of central banking stand on two pillars. One is that central banking would not be able to find monetary equilibrium because centralization in general destroys the market signals that separate individual banks would have. In a free banking system, each bank would have available to it immediate signals when it inflated or deflated. Thus, day-to-day or even more frequent adjustments could be made in regards to interest rates, loans, and reserves.
The other is that central banks have no incentive to seek monetary equilibrium. The central bankers' self-interest does not allign with promoting monetary equilibrium. The free bankers' self-interest alligns with it because consumers can always choose another bank. On margin, the free bank that inflates will lose reserves to other banks, while the one that deflates will lose customers and market share. A central bank does not face this problem. It can inflate or deflate and not have to worry about losing customers. The fact that inflation or deflation in central banks is never localized means, too, that the effects of either are spread out and hard to predict in the long run. This makes it even more likely that short run gains – reducing unemployment before an election, making loans to the government or influential groups (e.g., stock brokers), lowering interest rates in the real estate market – will trump both short run and long run monetary stability, and thereby long run economic coordination.
Horwitz expands on this to show how a culture of inflation and of using influence over the monetary authority results in more people chasing after other people's wealth than making their own. His point is central banking makes redistribution of wealth more palatable and more practical. This means, ultimately, more effort gets devoted toward taking than toward making – and less gets made.
He attacks full reserve banking – where banks act basically as warehouses for specie – for not be able to adjust to the effective demand for money. In essence, a full reserve banking system would not be able to adjust at all. Money and banking exist not as theoretical constructs, but as real world institutions. Moreover, their role in the economy is to facilitate exchanges. Anything that thwarts this role can rightly be seen as discoordinating and, thereby, as making such exchanges harder.
He tackles, too, the two main arguments made for full reserve banking against any form of fractional reserve banking. These are that the latter is inherently fraudulent and inflationary. The fraud claim is that if all note holders were to descend on a fractional reserve bank, they could not all be satisfied in full. After all, if only, say, a 20% reserve is on hand at any moment, then only 20% of the notes could be redeemed at that time. He answers this two ways. First, he states that unless a bank defaults in fact, there is no fraud. Potential default is not actual default. Second, he claims those who hold notes are not holding bailments but liabilities that are payable on demand. Note holders understand this and understand the risk involved. This by no means allows the banks to do whatever they will, but it does allow for fractional reserve banking on ethical grounds.
He also answers Hans-Herman Hoppe's criticism that fractional reserves reduce the real value of other people's money by driving up the price level. Hoppe argues, on libertarian grounds, that this "constitutes a coercive invasion in the form of a negative externality." (224) He argues that Hoppe "confuses technological and pecuniary externalities." The former are actual violations of physical property, the latter involve anything that someone does that might not be coercive but affects the market value of any asset. For instance, someone inventing a new car engine might make the value of older engines, equipment that makes them, and skills needed to repair them less valuable. In the same way, fractional reserve banking cannot be criticized for pecuniary externalities of this sort, especially if they are voluntary. (People can always opt out and decide to stick to barter, gold coins, or some other medium of exchange, though they will pay a penalty – in lost opportunities for exchange – for doing so. Horwitz does not stress this point enough, though its implied. It would be better for him to prune any counterarguments in advance.)
The inflation claim is the economically more important of the two. After all, if fractional reserve banking, free or no, is inflationary per se, then it will not promote monetary equilibrium and all the problems associated with inflation will apply. The claim is made that fractional reserve banks will create money regardless of the demand for it. Yet such money creation would ultimately lead to the inflating bank to lose its reserves – eventually to go bankrupt, if its policies do not change. The effect would probably be much quicker in regards to other banks – sounder ones; ones that weren't inflating – redeeming notes en masse against the inflating one.
But what of the claim that fractional reserve free banking would be inflationary because there would always be more paper money than there was reserves to back it? I.e., if a fractional reserve bank only holds a reserve of 20% – to recycle the above example – then it can have fives times as many notes in circulation as there are reserves to back them. This would, by some critics' lights, be an inflation rate of 400%! The answer is that inflation is not in regards to reserves but always in regards to the demand for money. Inflation is when there is an excess of money over the demand for it – not when there is more money than reserves. Thus, it is an equilibration of the demand for and supply of money defines monetary equilibrium – not the amount of reserves. Horwitz also tackles much more sophisticated forms of this view, but they all come down to this confusion.
Also, by this view, it is possible to have inflation as well as deflation under full reserve banking. How so? The supply of money cannot follow the demand for it since it is fixed by the amount of reserves. It can neither go up nor down – except when either the reserves themselves are diminished or increased. The price system itself would have to handle all fluctuations in the demand for money, which would lead to the price structure be less efficient and not reflect real changes, but would also include a strong monetary component in it.
Historically, too, there was no full reserve banking period that evolved spontaneously. A hypothetical full reserve stage has been proposed in the evolution of banking systems, but outside of such "conjectural history" there is no evidence for such a regime. Also, even within the conjectural history, full reserve banking quickly evolves into fractional reserve banking. (Cf. Dowd 1996, 10.) If full reserve banking is so good, one wonders why it did not take hold before legal tender laws came into effect.
He also criticizes the BFH system – a proposal that attempts to separate the medium of exchange from the unit of account – for being more like a mutual fund than a banking system. There are too many issues involved to cover all his arguments here, though one should be mentioned. He argues that the BFH system goes against what has evolved naturally in banking – sans government intervention. This is not as strong an argument, in my opinion, though it should by no means be disregarded. That it has not evolved spontaneously should give one pause, but not prevent speculation and possible experimentation on this matter.
Overall, Horwitz does an excellent job of showing how current and many proposed banking regimes don't work, that they promote economic instability, uncoordinate plans, and make for lower production of wealth. He does not go so far as to recommend specific means of dismantling the current system, though other authors he cites have made such proposals. (Cf. Dowd 1993, especially chapters 13-16, and Dowd 1996, chapter 16.) His goal, however, is not to flesh out detailed reforms but to place macroeconomics on a firm Austrian microeconomic foundation. In this he succeeds.
Bibliography
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Dowd, Kevin. 1996. Competition and Finance: A Reinterpretation of Financial and Monetary Economics. St. Martin's: New York.
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Hayek, Friedrich A. 1945. “The Use of Knowledge in Society,” in Friedrich A. Hayek, Individualism and Economic Order, Chicago: University of Chicago Press, 1980 [1948].
Horwitz, Stephen. Forthcoming. “The Costs of Inflation Revisited,” The Review of Austrian Economics.
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