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A question regarding Selgin’s response to Bagus and Howden

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Esuric posted on Fri, Apr 1 2011 11:16 PM

I just finished reading Selgin’s response to Bagus and Howden, and I must say that it appears as though he has successfully combated many of the criticisms levied against him and monetary equilibrium theory in general. That being said, he introduces an argument that I find somewhat confusing if not entirely untenable. I've probably misunderstood his argument and I’m confident that he, or other modern monetary equilibrium theorists (or those who are adequately familiar with modern MET) can coherently remedy my confusion.

He claims,

first, that, holding money proper is saving.….a prior increase in the demand for money constitutes an increase in real saving (or in real saving that is placed with the banks) and that the banks are in turn warranted in making new loans.

I don’t see any relationship between the demand for cash holdings and time preference. As far as I’m aware, the two are entirely independent of each other. It’s true that a higher demand for money must necessarily mean a corresponding diminution in either the demand for consumer goods and/or future goods, but I don’t see how an elevated demand for money, be it inside or outside money (money proper, money substitutes) constitutes an elevated demand for future goods.

So again, does he believe that an elevated demand for real cash balances may potentially mean a higher savings rate (a fall in time preferences), and if so, how?

Thank you.

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Esuric, the simple anser is that people are saving whenever they refrain from spending on current consumption.  Since a person who holds some money necessarily refrains from spending it for as long as he or she holds it, holding koney is necessarily saving.  But as I explain in my comment, whether an addition to real money holdings involves a change in overall saving or time preference or whatever depends on whether the addition comes from reduced consumption or sales of other assets. 

Note the distinction: money holdings always represent saving; additions to money holdings may represent additions to total saving, but they need not.  It isn't a paradox, though it may seem so, because money is only one of many alternative savings vehicles.  Likewise, all cats are pets, but not every increase in the cat population implies an increase in the pet population. 

Does this help?

 

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Esuric, the simple anser is that people are saving whenever they refrain from spending on current consumption.  Since a person who holds some money necessarily refrains from spending it for as long as he or she holds it, holding koney is necessarily saving.  But as I explain in my comment, whether an addition to real money holdings involves a change in overall saving or time preference or whatever depends on whether the addition comes from reduced consumption or sales of other assets. 

Note the distinction: money holdings always represent saving; additions to money holdings may represent additions to total saving, but they need not.  It isn't a paradox, though it may seem so, because money is only one of many alternative savings vehicles.  Likewise, all cats are pets, but not every increase in the cat population implies an increase in the pet population. 

Does this help?

 

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The Theory of Free Banking, Selgin, 1988, chapter 5, Increased Money Demand :

To summarize, a general increase in the demand for inside money is equivalent to a general decline in the rate of turnover of inside money. Bank notes change hands less frequently, and holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of inside money in a manner that accommodates the growth in demand for it. In standard textbook terminology, there is an increase in the reserve multiplier. Liability expansion continues so long as there are unfilled reservoirs of demand. Any issues in excess of demand, however, will lead to additions to the stream of payments, causing an increase in bank clearings and reserve requirements.

He could hardly be more clear, I guess.

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"Esuric, the simple anser is that people are saving whenever they refrain from spending on current consumption.  Since a person who holds some money necessarily refrains from spending it for as long as he or she holds it, holding koney is necessarily saving.  But as I explain in my comment, whether an addition to real money holdings involves a change in overall saving or time preference or whatever depends on whether the addition comes from reduced consumption or sales of other assets.

 

Wow, I must say I don't consider myself fully informed regarding the case for or against free banking but I've been thinking the same thing for a while!

 

Do forgive me for trying to turn a thread that was meant to answer 1 question regarding that article into , but from skimming I noticed early in your response you attacked Bagus et Howden for attacking you with regard to price stickiness in falsely alleging you to hold the belief that they were only sticky downward in adjusting PT=MV(and hence having an inflationary bias).

 

I think their cirticism would be a fairer one in practice if directed toward standard New Keynesian Economics, since price stickiness is adopted on an ad hoc basis there to explain unemployment in the labour market, with the only solution being inflation. On the face of it, for anyone informed about economics this claim should seem shaky, especially when one considers the number of restrictive and onerous labour laws faced by the market that would by themselves create such a distortion, not least of which would be the minimum wage; making for interventionists a self fulfilling prophecy. Also unexplained by their adhocism is why wages are never sticky upward, since we have no reason to believe this should be so from their theory. Therefore we are left uncertain as to whether such a phenomenon could really exist on a free market. Given that only downwardly sticky wages are "observed" this leads to an inevitably inflationary bias on the part of policy makers looking to achieve full employment. Would you agree?

 

Also, the following questions may seem absurdly ignorant, but:

1. Why should we care if MV stays constant or not?

2. If productivity increases in an economy were hypothetically so great that they caused prices to fall in an "inelastic" fashion such that PT dropped(inspite of any increases in T that would have resulted), would this be perceived as a problem from a free banking perspective, requiring monetary intervention to make up for the shortfall as a result of such a drastic price drop.

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Selgin replied on Sat, Apr 2 2011 10:06 PM

A:  Your question asks me to repeat here the sum of several of my articles and books, not to mention some essential monetary economics background!  So, no, I can't begin to do it!  I'll refer tyou to my pamphelt Less Than Zero; but even that requires some basic macro stuff as background.  Perhaps though not more than you already posess.

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Esuric replied on Sun, Apr 3 2011 12:38 AM

Selgin:
Does this help?

Indeed it does, and thank you for the quick response. Your position on this matter seems to diverge from the position held by Hayek in P@P and Mises' typology of economic goods. As I'm sure you know, Mises categorizes economic goods into three distinct classes, and Hayek asserts that time preference, i.e., natural interest, is solely determined by the ratio of demand between future and present goods. The demand for money has absolutely no effect on the natural rate of interest (though it obviously partially determines the money/market rate of interest). Liquidity preference and time preference are two entirely separate phenomena.

Also, I don't think that Mises distinguishes between the demand for inside money and the demand for outside money. There is a theoretical difference between them of course, but the demand for money is the demand for money in the broader sense (in other words, people don't distinguish between inside and outside money unless there is a panic).

Have I misunderstood Hayek's argument, or do you simply disagree with him on this particular issue?

Thank you for you time.

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From what I understand, Rothbard and the other Austrians had a different opinion on what constitutes saving compared to Selgin (I could be wrong though). In the catallacy, saving is when an individual refrains from consumption by sacrificing his availability of present goods (money that could be used for consumption) for later future goods (fund earned from investment). He has to reliquinish his availability of funds in order for it to be savings. If an individual keeps money in his cash balance, he is only relieving uncertainty, he could easily use those funds for either consumption or future capital goods. He isn't really sacrificing present consumption because he still has the availability to buy consumer goods with his money. He only satisfies his present end of a demand for money because of the uncertain future.

Here are some quotes from Rothbard that illustrate his (if I'm interpreting him correctly) point.

"Furthermore, he allocates between the various categories on the basis of two embracing utilities: his time preferences decide his allocation between consumption and investment (between spending on present vs. future consumption); his utility of money decides how much he will keep in
his cash balance. In order to invest resources in the future, he must restrict his consumption and save funds. This restricting is his savings, and so saving and investment are always equivalent. The two terms may be used almost interchangeably." (America's Great Depression p39)

"That is not the issue here, which is one of availability for use. If a man wants to “save” money for some future use, he may “hoard” it rather than spend it on a future good, and thus have it always available. We have abstracted from hoarding, which will be
dealt with in the chapter on money; it would have no place, anyway, in the evenly rotating world of certainty." (MES 386)

 

Demand for money can have an effect on time preference, depending on where the funds are taken from. If demand for money increases and it comes solely from consumption funds, time preferences will be lowered and so will interest. As far as I can tell, the decline in consumption and the release of factors from lower stages/shorter production processes will still flow into the higher orders and lengthen the structure of production, even if the individuals do not spend the hoarded money on investment. The prices of the higher orders will still rise relative to the declining returns in the lower orders and the economy will lengthen. The only difference is that consumer prices/wages will fall even further due to the increased demand for money and there won't be aggregate profits in the economy.

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C replied on Sun, Apr 3 2011 3:13 PM

I too have read both papers and remain thoroughly confused by Seglin's argument.  

I fail to see how an increase in the demand for money creates 'artifically' high interest rates that need to be offset by credit expansion and vice versa.  

If one increases his demand for money by reducing consumption and investment in proportion to ones original time preferences, the rate of interest will not change.  

If investment expenditures are reduced to accomdate the increased demand for money then, yes, interest rates will rise, but this is because time preferences have in fact changed.  I fail to see what is 'artifical' about this and why banks need to expand more credit to offset this increase.

And also, if banks do expand credit in the face of a rising demand for money, wont the funds have to be taken from their reserves (given no central bank)?  Wouldn't this just mean they are lowering their own reserve ratios to a more unsustainable level?  

Finally, on suspension.  While I understand that fractional-reserve banking could be done contractually, I find it hard to believe consumers would voluntarily chose to place their money in an account in which withdraws could be suspended at any time without notice.

Say its payday and I have no food in my house and I go to the grocery store to stock up.  I have the cashier ring up $200 worth of food then swipe my debit card only to but told - 'not approved'.  I call up my bank to see what the problem is because I know I just got paid.  They tell me, "Sorry but we have had to temporarily suspend withdraws.  You will have access to your funds sometime within the next 30 days as you contractually agreed to". 

So ya, I suppose its possible that people can contractually agree to it, but it completely defeats the purpose of a checking account.  Our entire commercial lives would be much more difficult if we had to put up with suspension.  Under these circumstances wouldn't a 100% reserve checking account out-compete a fractional reserve one with suspension? 

  At least he wasn't a Keynesian!

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How do people like Selgin and Friedman always show when something is asked about them?  Is someone emailing them?

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I've got to assume they've got bots, assistants, or they themselves skim various locations (or at least select hotspots with a high probability) for any mention of their name.

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Caley McKibbin:

How do people like Selgin and Friedman always show when something is asked about them?  Is someone emailing them?

They probably just google their name every once in a while. Actually, David Friedman said that a while ago.

If I wrote it more than a few weeks ago, I probably hate it by now.

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C replied on Mon, Apr 4 2011 11:05 AM

I have found a paper by George that answers my questions fairly well.

 

 
He does a good job of answering the critics on most issues.  I still don't know if I buy into the whole thing.  I would say though that I agree with the legal framework that would need to be applied to banking.  The idea that fractional-reserve accounts would be preferred by market participants in such a legal framework is questionable in my opinion.  He puts up the Scottish system as evidence of success of free banking with suspension clauses, but it seems to me that the history of fractional reserve banking is so replete with bank runs, that suspension would be more than just a rare occurrence.  I suppose the only way to find out for sure is to do it and see.
 
I will say, however, I don't agree with the whole monetary equilibrium thing.  Seems very New Keynesian to me.  Selgin himself suggests that the demand for money fluctuates much more than normal because of the government interference in the market and the business cycle.  I wouldn't expect large changes in the demand for money in a free market and if, in fact, "sticky" prices do exist, I don't see the need to make a big deal about it to the point of advocating an institutional framework to deal with it.  

  At least he wasn't a Keynesian!

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BlackNumero,

"If an individual keeps money in his cash balance, he is only relieving uncertainty, he could easily use those funds for either consumption or future capital goods. He isn't really sacrificing present consumption because he still has the availability to buy consumer goods with his money. He only satisfies his present end of a demand for money because of the uncertain future."

Right. And the fewer checks you write, the lower is the turnover of liabilities. In the face of falling bank clearings, banks have more reserves to lend. Here. As you said, this will lenghen the structure of production.

P.S. ... still have problems with quotes. Doesn't work.

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Not to sidetrack the thread, but I was talking about how the decrease in consumption will free up resources that could be used in longer production processes. Selgin's quote deals with the demand for inside/outside money and expanding the money supply to offset this increased demand. Depending on who you talk to, it seems like that could generate a business cycle (me :D). My point was for a 100% reserve economy.

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