Austrian Economics versus Keynesian and Monetarist Macroeconomics

Austrian Economics versus Keynesian and Monetarist Macroeconomics.

Mises U 2019

07/18/2019•Jonathan Newman

Recorded at the Mises Institute in Auburn, Alabama, on 18 July 2019.

The Picture-In-Picture Extension(By Google) is really helpful for reading and listening at the same time. Allowing you to pause/unpause and see the video without having to scroll all the way to the top of the page here.

Transcript table of contents:

Introduction

So thank you, everybody, for being here this morning. I'm Jonathan Newman, no relation to Patrick Newman as we've already covered.

I want to start off with a short story. I was perusing the New York Fed blog. The people at the New York Fed run this blog and write about different topics. This was a few years ago, and I found a blog about the panic of 1819, which I was sort of interested in.

I read through it, and I'm also a professor of economics, so I read papers that my students write. One of the jobs that I have when I'm reading papers is to check for plagiarism. You get an e-nose and make sure that the students aren't copying somebody else's work.

Unfortunately, while I was reading this blog from the New York Fed, there were some bits in there that sounded exactly like Rothbard's book "The Panic of 1819" – like, word-for-word actually. So, I felt like I did catch them plagiarizing Rothbard. The way that I know I actually did catch them is because they admitted to it afterwards.

After they saw there was a bunch of web traffic going to their article from mises.org, they noticed everybody was going to this old article about the panic of 1819. You'll notice that they added this author's update: "Murray Rothbard's 'The Panic of 1819: Reactions and Policies' was an additional source for this post and should have been cited. We regret this omission." To which I was thinking, "Man, I hope you regret it."

So the reason I start off with this is because I want to cite my sources here at the beginning. The major source for this talk is what I learned from Roger Garrison both at Auburn University and also in his lectures here. Not just the content but also his style. I've got some, hopefully, amusing moving parts in the PowerPoints. Rothbard was... or excuse me, Garrison was very famous for his moving parts in his PowerPoints.

So here we have Mises and Rothbard fighting against Friedman and Keynes. Here we go. They're about to throw the first punch—

Title

A little bit about the title.

I was very intentional with the title. It's a long title: "Austrian Economics versus Keynesian and Monetarist Macroeconomics."

There are just three points I want to make about the title.

First, Austrian economics is not divided into micro and macro. Hopefully, you've seen over the course of the week that we progressed from talking about human action and what are some of the things that we can say about human action that are necessarily logically true. What can we derive? What are the implications of the fact that we make choices?

Which is a sort of a micro focus. We look at one individual making a choice, and we tease out what sort of things apply to all humans making any sort of choice.

Then we develop into a theory of prices, a theory of money, a theory of interest, and so we can talk about how credit markets work. It turns out that this sort of light smoothly flows into talking about economy-wide phenomena like inflation and business cycles and economic growth.

So there's not Austrian microeconomics and Austrian macroeconomics. It's one edifice. It's one body of economics, and it's all interrelated. If you found out something that works in the or that you see in the macro economy that doesn't really accord with what Austrian micro might say, then that means there's some sort of disconnect. There's something wrong.

It seems like the macro economy shouldn't be thought of as anything more than just the sum of all the individual's preferences, exchanges, and what's going on. So why would we expect any to use a different set of tools to talk about macroeconomic phenomena as opposed to what happens at the micro level?

So for Austrian economics, all cause-and-effect happens at the micro level. However, does that mean that we can't talk about economy-wide phenomena? We can. So we have this integrated, fully integrated body of economic theory.

Mainstream economics, however, is divided. There are micro economists, and they're actually subdivided into further fields. There's labor, there's health, there's energy, all of these different subdivisions of micro economists in the mainstream. They all do their own little things in their own little fields.

Then there's this other group, this other umbrella of macroeconomists. Just from personal experience talking with people who work in both of those fields, they don't understand each other. I've been in seminars where it was a macro topic being presented, and the micro economists sitting there told me afterwards, "I, this doesn't make any sense to me."

So it's not just that they're doing different things or focusing on different things. They literally don't even understand each other, which is good evidence to show that it's almost like two totally different sciences, two totally different fields.

But this definitely doesn't apply to the Austrian school.

So this is why I called it "Austrian Economics versus Keynesian and Monetarist Macroeconomics." There's this entire body of thought that we're putting up against just the macro theories from the monetarist and the Keynesians.

Finally, notice that it's Austrians versus the Keynesians and the monetarists. They're grouped together, and they were on the right side of the screen in the Street Fighter example. So they're together, and I hope that we'll have time to show that the monetarists and Keynesians are actually very similar. They have very, very similar ways of approaching answering macroeconomic questions, and actually their policy prescriptions can line up as well.

Macroeconomics

There's some fraying at the top. So even mainstream macroeconomists understand that there are some serious issues with macroeconomics as it's performed today. I have a few quotes to show you this.

Noah Smith was commenting on how nobody in academic macroeconomics was able to predict the most recent financial crisis.

We have a quote from Paul Romer. This is from a great paper about mathiness, where he says, "Presenting a model is like doing a card trick. Everybody knows that there will be some sleight of hand. There's no intent to deceive because no one takes it seriously."

This is a pretty serious indictment against how macroeconomics is done.

Larry Summers says, "Real business cycle models have nothing to do with the business cycle phenomena observed in the United States."

Robert Solow, who developed a very important growth model in mainstream macro, has a serious critique of the dynamic stochastic general equilibrium models.

Mankiw, who wrote a very important principles of economics textbook, said that "the work of the past several decades in macroeconomics looks like an unfortunate wrong turn."

Finally, one of the presidents of the Federal Reserve District banks says that "macroeconomics has very little to offer by way of answers to the questions of why does an economy have business cycles and why do asset prices move around so much."

This is a pretty serious indictment, and what I'd like to offer today is that Austrian economics fills this gap. It doesn't have these sorts of errors, and so we'll see why.

Structure of Production

A brief review of what Austrian economics has to say about macro questions and macroeconomic phenomena.

I'm glad that David Houghton, at the beginning of his talk, showed how—I think he got this from Hayek—we need to understand how things can go right before we can analyze how things go wrong.

The way things can go right for a macro economy is if we lower our rate of time preference. If we decide that we're going to decrease how much we want to consume today, which means that we free up resources that can be used for investments so that we can produce more.

What that does is there's a restructuring, a total reallocation of how resources are used in the economy away from consumption and towards production, which means that we're allowing for more production of the goods that we would like to consume in the future.

This is the path to economic growth. This is the Austrian answer: how do you grow an economy? You save, you invest, you produce more. When that happens, entrepreneurs will change the way that they're producing things in accordance with the societal rate of time preference.

Hopefully, that's just a brief review of what you've already learned so far this week.

Equilibrium

How things can go wrong start with manipulation in credit markets. Specifically through the banking system, if we have an increase in the supply of money, this artificially lowers the interest rate and distorts the way production is done.

New money enters circulation through credit markets, which is a special case of Cantillon effects, and it lowers the interest rate. Entrepreneurs bid for factors of production and begin to implement new, longer lines of production just as if there were increased savings.

Incomes increase, which leads consumers to consume more and bid up the prices of consumer goods. Real investment, however, has not increased, so the entrepreneurs will find an increasing scarcity of the capital goods required to complete their projects, which leads to an increase in the cost of production beyond what they anticipated.

So they abandon those projects.

This is just a very short description of the Austrian boom-bust cycle, and it has a very specific, very certain beginning. We know exactly what causes it, and we can trace through the pattern of what will happen when we see this manipulation in credit markets.

Keynesian Economics

Let's do an overview of Keynesian macroeconomics. I'll do Austrians versus Keynesians, and then I'll do Austrians versus monetarists. At the end, I have a slide about how the monetarists and Keynesians are the same.

Keynesian macro is based on the circular flow model. This is the foundation of Keynesian macroeconomics, whereas the base or foundation for Austrian macroeconomics when talking about economy-wide things would be looking at the structure of production.

Keynes decided to look at the economy as if it's a circular flow. We have the households and individuals who provide the factors of production and own the firms and also consume the output from the firms. They purchase goods and services from the firms in this top market, the market for goods and services.

Firms produce that output by using the factors of production that they get from the households and individuals in the bottom market. They purchase those factors of production.

So we have a flow of money that emerges in the economy. Households and individuals are spending; that spending is revenue for the firms. The firms take that revenue and pay it out as income to the factor owners—the people who own the labor, the capital, anything that's different. It goes to entrepreneurship.

Entrepreneurs, or entrepreneurship, are viewed as a factor of production in this model, which is very different from the way Austrians would treat entrepreneurship.

This is taken as an equilibrium condition. If we have income, which is capital Y in this model, equal to the level of expenditures, which is capital E, then Keynes said we have an equilibrium.

This economy is stable. The spending on the top half is the same as the spending on the bottom half. The flow is even. If we can set these two magnitudes, these two spending flows, equal to each other, we get income equals expenditure, and this is the equilibrium condition in the Keynesian model.

Expenditures are disaggregated a bit into consumption spending, investment spending, and government spending, and also net exports. But just for our purposes today, I'm going to assume a closed economy.

Keynesian Cross

Consumption spending is C, investment spending is I, and government spending is G. The first graphical model using this equation was called the Keynesian cross or the income and expenditure model.

You take those three components of expenditure and stack them on top of each other, and that gives you the total level of expenditure in the economy.

C is consumption spending, and then you add investment spending, and then you add government spending, and that gives you the total level of expenditure. Notice that there's this diagonal line coming out of the origin. That's the equilibrium condition line. That's the line where all levels of income equal the levels of expenditure. If our economy is on that line, it means that we're in macroeconomic equilibrium from the Keynesian perspective.

You'll notice that only one of the components of the expenditure has a slope, and that's the consumption function there at the bottom. The consumption function is the only one that has a slope, and it's totally dependent on income. You add the intercept, which is autonomous consumption, and you have income multiplied by what's called the marginal propensity to consume, which turns out to be the only variable that goes into determining the Keynesian spending multipliers, which you've heard a lot about, I'm sure.

Then you stack on investment spending, which isn't dependent on income, and government spending, which also is not dependent on income. Notice the slope of that investment spending line and the government spending line is totally dependent on the consumption function, so you just sort of stack it on top. In my classes, I like to refer to it as a stack of pancakes. You've got a stack of consumption pancakes, a stack of investment spending pancakes, and a stack of terrible-tasting government spending pancakes.

The reason I talk about the stack of pancakes is because it makes it easier for students to think about taking some of those pancakes out. If we start taking away some spending, in the Keynesian model what's typically done is we say there's this unanticipated decrease in investment spending. You see that investment spending line? What I'm about to do when I click the button here is it's going to fall, but you'll notice that the top line falls down at the same rate. It does the same exact thing.

That's because what we're going to stipulate is that there is no response from the government. There's no government policy that steps in and says, "We're going to change the way we're spending because of the change in investment spending."

Watch what happens when we have an unanticipated decrease in investment spending. It wasn't very smooth, so they both fall together and the economy collapses.

The reason for that is because of a very important Keynesian assumption that's put in, and that is that wages are sticky. Everybody's heard of this, the whole sticky wage thing. Since wages are sticky, if we have a decrease in spending, which means that firms are receiving lower revenue, firms still have to pay those higher wages or those stuck wages, so they decrease output. But then they can't lower the wage so that they can have full employment at the new lower level of spending and the new lower level of output.

There's this inherent mismatch, these inherent persistent disequilibria in labor markets because wages are stuck at too high of a level for whatever reason. There are a few reasons that are offered, like maybe there's a psychological reason workers don't want to accept a lower wage. There may be legal issues, like what if the wage is at the minimum wage already, which means it's illegal to lower it. Whatever the case, if we have sticky wages, labor markets can't clear, and so the economy just spirals down into depression.

There's this initial decrease in investment spending that causes the whole economy to collapse, which, by the way, in the Keynesian system would happen a lot because investment spending is considered very unstable. It's guided by these animal spirits. It's impossible to predict. If investors are optimistic, then they'll increase their spending. If they're pessimistic, then they'll decrease their spending. That's basically it. It just comes out of nowhere. There are just major changes in investment spending that come from nowhere. Because of this inherent instability of investment spending, the entire macro economy is in this fragile position. So the whole economy crashes.

Aggregate Demand

Let's look at the Keynesian story of how things can go right. We had this unstable investment spending component. However, in this scenario here, we're stipulating that the government spending component completely makes up for any changes in the investment spending component.

So there's a rule: if there's a change in investment spending, then the government increases or decreases their spending to perfectly offset it.

You'll notice that the top line doesn't move in this case. Their animal spirits are moving that investment spending line up and down, so investment spending increases and decreases all the time because of animal spirits. But the government, thankfully, is there to step in and prevent us from spiraling downward into depression because whenever the investment spending pancakes come out, the government adds some pancakes right on top. So the total stack of the pancakes doesn't change. That's what matters. We just want the stack of pancakes to stay the exact same size so that we don't have the spiral downward effect because of sticky wages.

By the way, we're in the judge's room—or I guess I should say the judge's jurisdiction—and he allows questions. People have encountered these models in their classes, so it's okay with me if you raise your hands. We can have a more informal question-and-answer if you like. If you have any questions along the way, please raise your hand and ask.

So this is the Keynesian story of things working right. Government saves the day is the moral of the story.

That was an early Keynesian model. There was another model in between: the IS-LM model. Then after that came the aggregate supply and aggregate demand model. But the story didn't really change. The policy prescriptions don't change. If we have any sort of unanticipated decrease in spending—this time we'll call it aggregate demand—the aggregate demand curve is that downward-sloping curve here in this graph. If we have any decrease in aggregate demand, then we pull away from the long-run level of output, the full employment level of output. We slide down the short-run aggregate supply, sticky wages and misperceptions, other sticky prices. There are some funny things going on in the way these curves are sloped, but the moral of the story is the same. The only hope is for some non-market entity to decide to increase spending to offset the original decrease.

I've seen this graph used to explain the Great Depression. There was this unexpected decrease in investment spending, and then there was a subsequent decrease in consumption spending. Thank goodness FDR came in and increased government spending, and then we had a huge increase in government spending with World War II, and that's what allowed the aggregate demand curve to get us back to our long-run equilibrium.

Sticky Wages

Sticky wages is the Keynesian idea that wages can be stuck for non-market or maybe even non-voluntary reasons.

We know that wages are set by the laborer's diminishing marginal revenue productivity. If there's some sort of decrease in demand for labor based on the change in that worker's revenue productivity, what a Keynesian economist might say is for some reason the equilibrium wage in that labor market won't come down. It could be that the workers just won't accept it, they won't accept a lower wage.

Or it could be that there are regulations or cultural reasons for this. I've seen a number of different reasons for it, but the idea is that for some reason wages won't come down to the market-clearing rate.

There's a distinction between nominal wages and real wages. Even if the workers can achieve the same or even a higher real wage by accepting a lower nominal wage, the argument is that the nominal wages won't go down. They won't accept the lower pay even if the goods and services they can purchase with that lower nominal pay are the same or even higher. A lot of the reasons have to do with the psychology of workers and the wages they'll accept.

Any other questions before we move on? Okay, good.

Austrians vs. Keynesians

Let's compare the Austrian story with the Keynesian story. The shape of the business cycle for Austrian economists is boom and then bust.

We have a cause of the boom, and the cause is the artificial credit expansion. So it's boom and then bust.

For the Keynesians, the shape is bust and then boom. There's this unexpected decrease in investment spending that sort of comes out of nowhere, and then the government steps in and saves the day. Or there's some other exogenous spending—exogenous just means outside of the system—that allows aggregate demand to increase so that we get back to our long-run equilibrium.

So it's a bust and then boom. A lot of times when Austrians and Keynesians are debating each other, discussing business cycles with each other, just because the shape is different in the minds of these economists, they start to talk past each other.

If you consider the bust as the first part of the business cycle, then you're going to talk past or you're not going to be speaking the same language as somebody who considers the boom as the first phase of the cycle.

The causes are totally different. The cause for Austrians is the artificial credit expansion. For Keynesians, it's the instability of investment spending, specifically an unexpected decrease in investment spending.

The diagnosis for Austrians is the malinvestment and overconsumption that Dr. Houghton talked about in his lecture. We produced the wrong things in the wrong ways, and consumers increased their consumption beyond what they would have done absent the artificial credit expansion.

For Keynesians, the diagnosis is there's a steep decrease in aggregate demand.

The cure for Austrians is to simply let the bust run its course. Dr. Houghton did a good job explaining how the recession is actually the healthy process of figuring out where the factors of production should be in the structure of production. How should we be using all these capital goods and laborers that we have available? How should we be using all these resources in a productive and profitable way?

That's what the recession is: it's discovering, refiguring out how to produce the things that consumers demand.

The cure for the Keynesians is both expansionary monetary and expansionary fiscal policy. I didn't talk through the details, but there are two ways to increase aggregate demand by policy. You can increase government spending, which is a component of aggregate demand. We saw that directly in the old Keynesian cross model. We just increase government spending whenever there's a decrease in investment spending, then we avoid spiraling downward into depression.

However, in the aggregate supply and aggregate demand model, it's common for students to list out what are the shifters of aggregate demand. One of the shifters of aggregate demand is monetary policy. It turns out that if you increase the money supply through credit markets, you make it cheaper for businesses to borrow to purchase factors of production. You also make it cheaper for consumers to borrow to purchase homes and cars, so you can increase consumption spending and investment spending through expansionary monetary policy.

There's not as much literature that I'm familiar with, but it seems like it's easier to increase government spending as well when you engage in expansionary monetary policy because the government can finance its spending more easily.

So the moral of the story here is you can use expansionary monetary or fiscal policy to increase all sorts of spending in the economy, and that's the cure.

To restate the cure, Austrians would say we need to let consumer demand dictate how the factors of production are allocated, how resources are allocated. We want prices to be in accordance with consumer demand, including the imputation of value from the consumer good back to the factors of production. We want consumer demand to reign supreme.

The cure for the Keynesians, as I've stated, is the government needs to step in and be in charge of what prices are and what spending should be. This is a very critical point in my lecture.

The prevention for Austrians is to not let there be an artificial credit expansion. Basically, leave money production out of the whims of bureaucrats. Don't let money production belong to somebody who can just increase it or decrease it, especially if the increases come through credit markets.

The prevention for the Keynesians is to let the government have complete control in these sorts of cases. We need the government to have the ability to increase and decrease spending, increase and decrease the money supply, in case we have this sudden decrease in aggregate demand.

The reason I said this is a critical point is because you'll notice that the prevention for the Austrians is the cure for the Keynesians. Keynesians say we need to use expansionary monetary policy to fix recessions. Austrians say no, that's what caused the problem in the first place. That's how you prevent future booms and busts. That's how you prevent the business cycle.

So there's a very extreme divergence of views in terms of the view on expansionary monetary policy.

Monetarism

Monetarism is not very complicated. It's really just one equation. They sort of hang their hat on this quantity theory of money. We can explain almost all, maybe all, macroeconomic phenomena just by looking at the quantity theory of money, also called the equation of exchange.

Let's review the elements here.

We have the money supply, which is M. Skip over V for a second. P is the price level, which I talked about in my previous lecture. If you weren't there, there's no such thing as the price level. I'll talk about that later. And then Q is output. Sometimes it's T for the total volume of transactions or lowercase y for real output. I prefer just Q; this is how Roger Garrison taught me, and by golly, I'm going to follow Roger Garrison.

So MV equals PQ.

The reason I saved V for last is because it's actually defined by the other elements in this equation. V is called the velocity of money, or the velocity of circulation of the money supply, the turnover rate of the money supply, or how many times the average dollar is spent in the economy.

You get this by taking the total level of expenditure, which is prices times the quantity, P times Q, and you divide it by the money supply. V is literally—it's like when it's super endogenous, it's defined by the other variables in the system. Rothbard, in "Man, Economy, and State," has a very good section talking about how absurd it is to have a variable in this equation that's only there because you need it to make the two sides equal each other.

This is important because there's no such thing as the velocity of money in purely logically derived economic theory. The velocity of money doesn't enter into anybody's choice. When I'm going out to the grocery store to purchase the elements to make a burrito, I'm not considering, "What is the velocity of money today?" I'm also not considering, "What is the general level of prices?" I'm making my own individual choices based on my value of the cash that I have, my cash balance, and also the goods that I would use to construct the burrito.

The velocity of money is a strange figure here, but it's defined as the total level of expenditure, P times Q, divided by M, the money supply. If you have $100 in a very small economy, $100 worth of spending, and only $20 exist in this economy—so the true money supply, the money supply for this economy, is $20—it would take spending that $20 on average five times to achieve the total level of spending. That's a good way to think about what the velocity of money is.

Friedman's Approach

How do we use or how do we think about this equation? It depends on who's writing, which monetarist you're reading.

Friedman, probably the father of monetarism, assumed that the velocity of money is relatively constant. It doesn't change much from year to year. Over the timespan he was looking at, there's been some debate over whether he fudged the numbers or smoothed it out too much. But in his book "A Monetary History of the United States," over the time period he was looking at, it was relatively stable.

Now, outside that time period, it's been shown that there have been some pretty big changes in the velocity of money. But for Friedman's use of this equation, he assumed the velocity stays constant.

As a policy goal, we're going to try to stabilize prices. The policy goal of Keynesians was to maximize employment and maintain that full employment level of income. The policy goal for monetarists is to keep prices stable. The idea here is that if we keep prices stable, that makes it easier for consumers and businesses to make decisions about the present and the future.

If they can more confidently, with less uncertainty, make those decisions because of a stable price level—prices aren't changing too much—then we'll have consistent economic growth, which would look like this. We'll have steady increases in Q, steady increases in output, which means for this equation to balance out, you have to have the same increases in M at the same time. Simultaneous or balanced increases in output with increases in the money supply.

Here you can see immediately there's going to be a big disagreement between monetarists and Austrians about increasing the money supply, specifically because Austrians will say if you increase the money supply, then you're going to start the boom-bust cycle.

This is one way of looking at the elements of the equation of exchange. The way I've seen some monetarists describe the Great Depression is that the Fed allowed this big decrease in the money supply. They allowed all the bank failures, which caused the money supply to collapse. The money supply decreased, and there was this big decrease in output. Actually, it was so big, and because of the price level—the money supply was falling, prices also fell, and the velocity fell. So we had these decreases all around. The Great Depression was just money supplies falling, the velocity of money was falling as people were more reluctant to spend money. So the velocity of money decreases, prices also fall, and output obviously fell by about a third.

This is the main apparatus that monetarists use to analyze macroeconomic phenomena.

Criticism of Monetarism

This is not cherry-picking. This is a direct quote from the book by Friedman and Schwartz. They say, "Changes in the behavior of the money stock have been closely associated with changes in economic activity, money income, and prices. The interrelation between monetary and economic change has been highly stable. Monetary changes have often had an independent origin."

If we have a central bank that has discretion over the money supply, that's what they're talking about, that independent origin. They have not been simply a reflection of changes in economic activities. So we can use M as a policy variable, outside of the market system, to achieve the macroeconomic ends that we would like—namely, stable price levels so that we can have consistent economic growth.

What are the Austrian responses to this? There are quite a few.

Probably the most fundamental response is that the analysis starts with data availability as opposed to sound economic theory. They're not starting from the ground up—how do people make choices? Why do people purchase this as opposed to this? Or talking about things from a micro-foundation, as some economists might say.

It starts with, "Well, we've got this money supply data. We can construct data on the velocity of money by taking total expenditures and dividing it by the money supply, and we know it's true. So it has to be true that the money supply times the number of times it's spent must be equal to total expenditure, price times quantity."

So we have this data. Let's use this as our main apparatus of considering changes in the macro economy, as opposed to the Austrian method, which was we start with human action. You get diminishing marginal utility, you get the law of demand, the law of supply, and onwards and upwards until you construct this massive business cycle theory or critique of socialism, for example.

Another criticism is that—well, this isn't really a criticism, it's just a statement—MV equals PQ is a tautology. There's really no argument over the truthfulness of this. Even if you consider P an array of prices or a vector of prices, you can still multiply it by the vector, the horizontal vector, of all the different goods that are produced in the economy. So you can still calculate total spending on the right-hand side, and that must equal—there's no arguing over this—the money supply times the velocity, if the velocity is defined as whatever number it takes to get these two sides to equal each other. So there's no argument over the truthfulness of this equation.

The argument is over the cause and effect. If you just look at an equation, the cause and effect isn't clear. In fact, if you notice the two examples that I went through, one time I started with an increase in output and said, "Well, what that implies is that we need to have a monetary policy like this."

In the other example, I said, "Well, suppose we allow the money supply to collapse. What's going to happen to the other variables in the system?"

So there's this big question over which variable causes what. Which one is endogenous? Which one is exogenous? What direction is the cause and effect here? It's not clear just from the equation where that is, as opposed to the Austrian apparatus, the Austrian theory, where cause and effect is at every step along the way.

Mises' Critique

Here's a nice quote from Mises. He says, "It's essentially nothing"—he's talking about the equation of exchange—"it's essentially nothing but a mathematical expression of the untenable doctrine that there is proportionality in the movements of the quantity of money and of prices."

This is not just a critique of the equation of exchange but also of thinking about changes in the money supply having a proportionate or even effect on the general level of prices.

Mises did a total smackdown of thinking about that relationship as a mechanical one. If we increase the money supply, there's going to be this sort of effect in general on the price level. Thinking about all prices changing in one direction versus another direction, Mises totally smashed that.

It turns out that there's no way to do that. Even in the angel Gabriel model, there's no way to say for sure that all prices are going to rise evenly or decrease evenly if there's some sort of change in the money supply.

Austrians would also say there's no such thing as the price level. As a number, we can't just plug in one number in this equation. There's no such thing as the price level. The closest thing we can get to is a constellation of prices.

One of my favorite analogies is the swarm of bees analogy. The price level is like a swarm of bees—all of these prices that are moving in relation to each other. The swarm can go up, the swarm can go down, but if you're just looking at the midpoint of the swarm of bees, you're sort of missing the whole point. You're missing all of the relative changes, all of the Cantillon effects that might happen.

Another criticism is that there's no reason to seek to stabilize P. In fact, Austrians would say the whole point of prices is for them to be able to move up and down in accordance with the total stock of some good and the demand for that good.

We want prices to fluctuate. We also want prices in general to be able to fluctuate in accordance with people changing their demand for money. We need prices and the entire price level to be able to fluctuate. Seeking to stabilize the price level seems arbitrary. Why seek to stabilize something that we need in the functioning of a market economy? We need prices to be able to change.

We've already talked about how V is pretty much meaningless. There's another quote from Mises here: "The mathematical economists refuse to start from the various individuals' demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics."

Mises also criticized the idea of money circulating, period. At any given moment, all dollars are held by somebody. They're in somebody's cash balance. Even in a transaction, one moment the money belongs to one person, and the next moment it belongs to the other person. It's not really good to think about money circulating through the economy, even though I tend to use this phrase as well. But if you're thinking about the circulation of money either from a Keynesian or a monetarist perspective, you're sort of missing out on the fact that money is demanded to be held in individual cash balances by individuals, as opposed to thinking about money as this independent, abstract variable that's flowing through the economy either in a circle or being turned over, like in the quantity theory of money.

Once again, similar to the Keynesian critique that we saw from the Austrians, the policy prescription in a recession, which is expansionary monetary policy, restarts the boom-bust cycle. Friedman was very famous for saying that the Fed should have stepped in during the Great Depression, or during the initial crash in the money supply. They should have stepped in and prevented that decrease in the money supply by bailing out banks, by increasing the money supply through various means. This is what causes the boom-bust cycle for Austrians once again.

The Mississippi Monster

This is a good analogy of the problems of monetarism from Roger Garrison: the case of the cabbage-eating Mississippi monster. We'll work through this and see what Garrison has to say.

Suppose that in late October of 1929, a thousand-pound monster showed up in Mississippi. It spent the next three and a half years eating all the cabbages and quite a few rabbits between Jackson and Pascagoula. By early March of 1933, the monster weighed four thousand pounds.

Two investigators are sent to Mississippi to get a handle on the situation. One is from Vienna, the other is from Chicago.

The Viennese investigator asks, "Where in the world did this hideous thing come from?" The analogy here is that Austrians see a business cycle and they look for what caused it. What caused the boom that preceded this bust? They're going to look for expansionary monetary policy. They're going to look for new money entering the economy through the credit markets.

Garrison says here, "I seem to stack the cards against the Austrian. It's hard to even imagine an insightful answer to this question unless, of course, the monster turns out to be the unintended consequence of some ill-conceived government-sponsored bionics project."

I wonder if Stranger Things could approach Roger Garrison for some ideas on Stranger Things season four. This would be a great story there.

The Chicagoan shows up, shoves the Austrian aside, and says, "Never mind how this thing got here. The real question is how did it grow from a thousand pounds to four thousand pounds? How did an ordinary run-of-the-mill garden-variety monster quadruple its weight in 40 months? How do these small recessions turn into big recessions?"

The Chicagoan's answer, of course, is, "It was all the cabbages. It's the cabbages' fault that the monster was eating. He couldn't get good data on the rabbits, unfortunately. The correlation between cabbage consumption and weight gain leaves no doubt about the issue."

This is a fun story to show how monetarists look at recessions and business cycles compared to how Austrians look at business cycles. Austrians show up and ask, "Where did the monster come from? Where did the bust come from?" They're going to look at the boom.

Chicagoans, when they're looking at changes in the variables after the fact—when they're looking at changes in the money supply, changes in price, changes in output once there is a bust—they can talk about this all they want to. They're still not asking the right question, which is, "Where did the bust come from in the first place?"

Just as an aside, if you're interested in researching the shape of Friedman's business cycle model, you should google the plucking model, P-L-U-C-K, plucking model. It's like there's this long-run growth trend, and you can pluck down this line and get the bust and then the boom.

The shape for the business cycle for monetarists is the same as the Keynesians—bust and then boom. So Keynesians and monetarists are in the same camp in terms of shape as well as other things, which we'll get to in one second.

Milton Friedman died before the financial crisis, but he lived long enough to have the opportunity to see what was happening while the housing bubble was being inflated. Professor Salerno found this quote.

I think it's important. Friedman was interviewed by Charlie Rose in December of 2005 when it was becoming very obvious that there was a housing bubble. Actually, even in 2002 and 2004, you can find some of the earliest Austrian predictions of the housing bubble and the consequences that came.

Here's what Friedman said: "The United States is at the peak of its performance in its history. There's never been a time in the United States when we've had the state of prosperity, its level, and its spread that we've had in the last ten or fifteen years. There has never been a fifteen-year period in which there has been so little fluctuation in prices, in inflation. Inflation has stayed around two or three percent or less for the last 15 years. It's unprecedented. I certainly do"—and then it's implied in the interview—"give credit to Alan Greenspan for that. I think monetary policy is primarily responsible for it."

So Friedman totally missed it. I know it seems unfair because he's dead now, but if we can show that monetarists didn't predict this, not just Friedman but other monetarists didn't predict this, but Austrians did, it seems like we should take a good look at the perspective in which they were predicting what happened.

Similarities Between Monetarism and Keynesianism

Here they are.

Both start their analysis with data availability. What sort of macroeconomic aggregates do we have available? What can we tally up? What can we count?
As opposed to the Austrian position, which is, "Let's make an entire edifice of necessarily true, apodictically certain economic theory and then see what we can say about the economy."
As opposed to what the monetarists and Keynesians do, which is, "What data do we have and what can we do with that data?"

The MV equals PQ equation—I don't know if anybody picked up on this—is actually the same thing as the Y equals E equation. They're both tallying up total expenditures for the economy just in different ways.

The Keynesians disaggregate expenditure between consumption spending, investment spending, government spending, and net exports. The monetarists will disaggregate it—actually, there's less disaggregation, more aggregation on the monetarist side than there is on the Keynesian side.

At least for Keynesians, they disaggregate Q into the different types of products that people are consuming—consumption, investment, and government. But we just have Q; we just have total real output there for the monetarists. So there's a higher level of aggregation even on the monetarist side.

The policy prescription is the same. Keynesians would say, "Yeah, we can use expansionary monetary policy to get us out of the depression, to solve the bust."

So we had the bust and then the boom. Keynesians would add, "Yeah, we can also use fiscal policy." Monetarists are generally distrustful of using fiscal policy and using that part of government to fix the problem, but they're okay with using monetary policy just like the Keynesians are.

So there's total alignment in terms of the policy prescription from both monetarists and Keynesians.

Here's a quote from Friedman: "We all use the Keynesian language and apparatus." He just says that he rejects the Keynesian conclusions. I would argue that his conclusions seem pretty similar.

Here's a quote from Krugman that I got from Robert Murphy's blog post. You can always count on Murphy to find those good Krugman quotes.

Krugman said, "Old-style Friedman-type monetarists who focus on monetary aggregates are essentially in the same camp as Keynesians."

So why don't they just hug and kiss and make it clear to everybody in the world?

Thank you very much.