What if it’s a race? The lowered interest rates are used to inject new money into the economy, and this new money is used to bid up prices of capital goods because capital goods haven’t increased to match the increase in money. Even if entrepreneurs know exactly what’s happening, they will try to get as much of the capital goods as they can before they run out, instead of letting others get them and leave them in the cold. I suppose the smart entreprenuer could create a scalable project, one that could be scaled back once they realize that more capital isn’t available. Not an easy thing to do, though. Even then, that’s no guarantee that consumers will support the end products of these projects, since they didn’t save for them–and capital redistribution has already occurred when businesses were busy bidding up the prices of capital goods.

Funny, my expectation would be that credit expansion by the government would have more or less the exact opposite effect Murphy claims. That is, I would expect it to cause production to shift away from current goods and towards future goods.

To Current and Som:

Some mainstream economist could point out the fact that price system is unable to transmit information about inflation without delay. This time lag, as it seems, is core of your argument. Consumer has been robbed of his money and yet he goes on spending without knowledge about his diminished wealth. But this is very strange notion I cannot comprehend. Logic of this robbery necessitates change of structure of production. Without such change thieves could not profit from their foul deeds, only if enterpreneurs serve them instead of former customers then their immoral goals are accomplished. Thus there can be no merry meantime when everybody can spend, when both robber and his victim do the consuming. Either production is redirected or not, either robbery took place or not.

Following example should throw more light on this problem. Lets say there are two groups, plum consumers and apple consumers. If one thousand former apple consumers shifted to plums, then increased demand for plums would have to raise their price (at least in short run). Vice versa, apples would be cheaper. No, says mainstream economist, prices are sticky (market imperfection is their favourite topic), therefore plum and apple prices cannot change fast enough. But this means that new plum consumers cannot get any plums while some apples are left to rot. Production scheme has not been altered at all because prices remain intact. Only through change in prices market can restore equilibrium, apple consumers must get their apples at lower price while plum consumers must pay more. This means loss for apple producers and gains for plum producers. It is very reason why some apple producers shift their production to plums.

Since there can be no change of production schemes without prior change of prices then there can be no time lag between robbery (inflation) and adjustment of consumer spending because the very act of robbery necessitates price changes.

Kilmore: “Some mainstream economist could point out the fact that price system is unable to transmit information about inflation without delay. This time lag, as it seems, is core of your argument. Consumer has been robbed of his money and yet he goes on spending without knowledge about his diminished wealth.”

That’s right. It is not just an argument of mainstream economists, but one of Austrian economists too.

Kilmore: “But this is very strange notion I cannot comprehend. Logic of this robbery necessitates change of structure of production.”
Exactly.

Kilmore: “Without such change thieves could not profit from their foul deeds”
No. No major changes in the structure of production are needed to suit them. Assuming they have similar tastes to others of course, which is not unlikely. What changes by theivery and redistribution is the direction to which production is put. Inflation though changes both where production is directed and the structure of production.

Kilmore: “only if enterpreneurs serve them instead of former customers then their immoral goals are accomplished.”
Yes.

Kilmore: “Thus there can be no merry meantime when everybody can spend, when both robber and his victim do the consuming.”
Yes there can be capital consumption gives the answer.

Kilmore: “Either production is redirected or not, either robbery took place or not.”
Production is redirected and the structure of production changes.

Kilmore: “Following example should throw more light on this problem. Lets say there are two groups, plum consumers and apple consumers. If one thousand former apple consumers shifted to plums, then increased demand for plums would have to raise their price (at least in short run). Vice versa, apples would be cheaper. No, says mainstream economist, prices are sticky (market imperfection is their favourite topic), therefore plum and apple prices cannot change fast enough. But this means that new plum consumers cannot get any plums while some apples are left to rot. Production scheme has not been altered at all because prices remain intact. Only through change in prices market can restore equilibrium, apple consumers must get their apples at lower price while plum consumers must pay more. This means loss for apple producers and gains for plum producers. It is very reason why some apple producers shift their production to plums.”
Your example economy has no capital goods, which is what is at question here.

Kilmore:”Since there can be no change of production schemes without prior change of prices then there can be no time lag between robbery (inflation) and adjustment of consumer spending because the very act of robbery necessitates price changes.”
No. The nature of capital means that changes are real.

To give an example. Let’s say we have two groups of people. Group A and group B.

Group B embezzle wealth from group A. They do this by persuading a central bank to issue money to them.

So, on day 0 each member of group A has £30000 and each member of groups B has £30000. The price level is stable.

On day 1 the central bank print the money and give it to group B. At this stage group A have £30000 and group B have £40000 each. Note no extra wealth has being produced.

On day 2 group B start spending their money. The price level begins to rise. Both groups have judged their future spending plans on the basis of the price level on day 0, making appropriate provisions for what likely future price increase. Long term spending, such as on capital equipment will be judged on this basis.

Only by day 150 does this work itself out. By this time the members of group B have spent most of their extra money. However the plans of both groups were based of thinking that they were richer than they actually were. As a result distortion of the structure of production occurred.

Once prices begin to increase people’s planning is shown to be incorrect. At this stage the recession begins.

Luis Enrique,
are you suggesting that monetary inflation and interest rate manipulation does not cause capital consumption? You bring up depreciation. I suggest you read Reisman for a background on the effects of inflation and taxes on capital gains and the detrimental effect that these combined have on the capital stock under a fixed depreciation schedule. Traditional economic theory has a very limited understanding of the time structure of production. When you ignore the fact that production takes time, you can not account for the overconsumption which takes place when scarce resources are bid towards both consumption and capital goods as directed by the false price signal in the manipulated supply of loanable funds. It is quite obvious looking at historical business cycles that resources were misallocated, capital was consumed, and overconsumption did take place. If you have a problem with the reorganization as specified by Robert Murphy, it must be of degree and not of kind. Theory and History are against you on this argument.

To Current:

Even if thieves had the very same taste as their victims the need of price adjustment would not be undone. There is new demand if nothing else. Once prices are readjusted (and that must take place instantly after attempt to spend new money) all victims are aware of inflationary robbery because they cannot buy expected amount of goods and services. Why then should victims go on according to yesterday plans? They face impoverishment, therefore they must act upon new data, not to continue now inappropriate projects.

Of course some past projects are revealed to be unprofitable under new circumstances, thus they are abandoned. Consequently there is some “capital spending”, something is wasted during the transition period. But as soon as the inflationary scheme is firmly established, then new capital structure mirrors new consumer demand (altered original one). This means that central bank should not try to “tune” anything because any change of their policy is very costly, Friedman was right about this. However this is not business cycle, inflation alone cannot fool people. Yes, somebody might err for certain time, but such mistakes are always present, they would be present even under deflation. Yet we see error everywhere during boom periods. How is that possible? My attempt for explanation (I have already described it above) is somewhat different.

If you lent some money to your friend for next six months your consequent actions would be based upon some estimate of his trustworthiness. Lets consider following two cases, absolute certainty and only half certainty of pay off. If you are absolutely sure then you may plan to buy rare vintage car in six months + 1 day, you may even sign contract with its current owner. You would not sign it if you were only half certain about your friend’s trustworthiness. This simple example explains crucial role of risk assessment.

Now we have got lots of fractional reserve banks here and great part of money supply consists of demand deposits or another contracts. These banks are your friend from example above. During the boom period everyone is absolute certain about their trustworthiness, everyone acts as if there were no doubt about them (I mean every depositor). This means that many people based many decisions upon mere illusion, they plan to buy cars, houses, jewelry and so on on in “six month+1 day”. How can be they so sure? Because we all trust banking system, because there are printing presses running behind it, there is compulsory deposit insurance and there is of course government promising to bail-out every big enough bank.

This is the reason why consumer demand is too high during boom. We all think of our contracts with banks as of absolute certain ones. It is delusion, because bankers make many very risky investments. Why? Because risk is socialized. Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it. It is well known tragedy of commons, every shepherd aims to exploit as much as possible without regard to capacity of “pasture”. These risky investments explain enthusiasm of enterpreneurs. To them it is fulfillment of all their wishes, consumer demand is high and interest rate low simultaneously.

Risk demands creation of pool of reserves, uncertainty must be met by redundant capacity (machinery, storage, more employees, unsold product, cash holdings and so on). Exhaustion of reserve reservoir brings abrupt end of boom. Consumers try to cut their excess spending, to recover their cash holdings, enterpreneurs must stop their business, everyone is forced to pay except bankers. They simply wait for goverment to pour money into their failing companies.

Thus business cycle is obviously hidden in very nature of our banking system, while inflation is merely convenient method of its funding. This system would run smoothly on any money, not only newly printed inflationary greenbacks. Moreover inflation is not the only scheme employed. Law prevents true competition and enforces compulsory deposit insurance while government is ready to fund banks directly if necessary.

Mr. Murphy, you’ve done good. Real good.

Kilmore: “Even if thieves had the very same taste as their victims the need of price adjustment would not be undone. There is new demand if nothing else. Once prices are readjusted (and that must take place instantly after attempt to spend new money)”

Jeremy has dealt with this point. I agree with everything he has said. Prices do no adjust instantly.

Kilmore: “Yes, somebody might err for certain time, but such mistakes are always present, they would be present even under deflation.”
The errors though would not be systematic. Cental bank money issue causes systematic errors.

Kilmore:”This is the reason why consumer demand is too high during boom. We all think of our contracts with banks as of absolute certain ones. It is delusion, because bankers make many very risky investments. Why? Because risk is socialized. Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it. It is well known tragedy of commons, every shepherd aims to exploit as much as possible without regard to capacity of “pasture”. These risky investments explain enthusiasm of enterpreneurs. To them it is fulfillment of all their wishes, consumer demand is high and interest rate low simultaneously.

Risk demands creation of pool of reserves, uncertainty must be met by redundant capacity (machinery, storage, more employees, unsold product, cash holdings and so on). Exhaustion of reserve reservoir brings abrupt end of boom. Consumers try to cut their excess spending, to recover their cash holdings, enterpreneurs must stop their business, everyone is forced to pay except bankers. They simply wait for goverment to pour money into their failing companies.

Thus business cycle is obviously hidden in very nature of our banking system, while inflation is merely convenient method of its funding. This system would run smoothly on any money, not only newly printed inflationary greenbacks. Moreover inflation is not the only scheme employed. Law prevents true competition and enforces compulsory deposit insurance while government is ready to fund banks directly if necessary. ”

No, you are misunderstanding the problem. To give an example, in my home country of Britain the banks once used the gold standard. They also had a central bank that acted as lender of last resort, The Bank of England.

In that banking system there were socialized losses but no inflationary money issue. It’s problems were quite different. There could be no money printing boom that to make people feel richer. However, there was still a cartel of lenders.

The presence of this cartel didn’t mean that risk was particularly high. More that banks had an advantage over other organizations.

You say: “Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it”

In the past a bank that lost on high risks would be bailed out, but would not be able to make profits because of the high cost of the bailout. So, each bank did not bear only a small part of the risk, they bore most of it. So, each bank had an interest in lending responsibly even though it was not as strong as it should have been.

The problem though was that the central bank gave them a special privelege in acting as lender of last resort. It was not like the tragedy of commons, but rather more like a welfare system and had similar issues.

Things are fundamentally different when the government control the interest rate and influence the money supply.

To Jeremy:

The very act of inflationary theft requires price change. Without such adjusments production structure would not change a bit and therefore thieves would not get their desired goods and services because enterpreneurs would still serve to original customers. Thus it is impossible to separe price adjustment from inflationary theft, they occur in the very same moment, there is no time lag between them, the word instantly was not misplaced. Moreover price adjustments are prior to production adjustments (because prices govern production and not the other way around). Thus thieves must FIRST announce their robbery to get what they wish.

To Current:

I just cannot agree. If central banks did nothing else than printing of new paper (I mean really printing) then there would be no business cycle at all. Similarly gold mining does not cause business cycle. The reason is not as some suggest relatively small amount of mined out metal. Even swift inflow of gold into economy would not cause any cluster of errors.

One serious problem of your example (Britain under gold standard) is the fact that it supports my position, not yours Though it was impossible to create money per se, for it was impossible to print gold, business cycle was present. This is exactly what I say. Socialized banking system must always cause boom-bust, inflation is only easy way to finance it. Interestingly some Englishmen recognized the problem and its link to banking system, see currency school. Mises was inspired greatly by their views.

If government imposed tax on tax holdings, for example three percents, and then gave this huge sum to central bank thus enabling it to lower interest rate what would be the difference between such scheme and inflation? None. Yet you would be rather unwilling to relate taxation with business cycle.
That’s it. Inflation is just another tax while structure of our banking system is real menace causing cycle.

This stance has got many many advantages. I have already mentioned its compatibility with free banking some few posts above. If mere printing of money cannot cause business cycle then there is no reason to enforce full reserves. Thus there is no need to supress any forms of contracts, not even fractional reserve ones. Another advantage has been mentioned in this post, there is no problem with gold mining, it cannot cause no matter how successfull it might be. Moreover there is no need to be “golden bug”, to fight for restoration of that “barbarous relic” as mainstream economists view it. We could finally convince mainstream if we were for free banking and not for gold. (of course it is disguise, free banking would re-introduce gold)

Kilmore: “I just cannot agree. If central banks did nothing else than printing of new paper (I mean really printing) then there would be no business cycle at all. Similarly gold mining does not cause business cycle. The reason is not as some suggest relatively small amount of mined out metal. Even swift inflow of gold into economy would not cause any cluster of errors.”

I disagree. A swift inflow of gold would perhaps not cause problems if the money holding public knew about it. The problem though is information. You say that if central banks only printed money then there would be no business cycle. I fail to understand why.

Holders of money do not know how the central bank will behave, they cannot make plans for it. A business cycle is inevitable.

Kilmore: “One serious problem of your example (Britain under gold standard) is the fact that it supports my position, not yours Though it was impossible to create money per se, for it was impossible to print gold, business cycle was present.”
There were crises under Britain’s gold standard. However they were linked to wars, foreign events and devaluations.

Kilmore: “Socialized banking system must always cause boom-bust, inflation is only easy way to finance it.”
You keep saying that, without presenting an argument for it. Why?

Kilmore: “If government imposed tax on tax holdings, for example three percents, and then gave this huge sum to central bank thus enabling it to lower interest rate what would be the difference between such scheme and inflation? None. Yet you would be rather unwilling to relate taxation with business cycle.”
I think what you are suggesting is that the government impose a tax on money holdings. Let’s consider what would happen if they did this. A large amount of money would leave the accounts of money holders. This would obviously drive up interest rates as financing becomes more scarce.

That money would then be transferred to the central bank. Now, how would the central bank decrease interest rates? To do so they must lend out what they have taken from taxes and increase money supply. In your scheme it is unlikely if the interest rate could actually be changed. To change the interest rate requires money issue or destruction of money.

Question: What are some examples of intermediate goods that we’ve seen neglected in this (and/or past) recession(s)?

Thanks for an excellent post!

Your very long example doesn’t really illustrate anything, because you assume that labor is fully engaged, and that the economy truly is capital constrained. If you wanted your example to hold up, you should have added 10 idle workers who were fired from their jobs as fishermen and sushi makers, and 10 more idle folks who had been out of work for more than a year from their previous jobs as boat maintainers and rice gatherers.

But you are assuming that the economy is already at full capacity and that Krugman is simply advising them to shift their allocation of resources. That is not the situation we are in today, nor is it the one Krugman and his camp are discussing. Today, I think it’s pretty clear that the economy’s not operating at full capacity (and if you dispute that, I’d love to hear your argument), and the question is not only why that is, but also how we can get it back on track.