I haven’t been too involved with the debate on Cantillon effects, largely because I’ve been busy with other things. But, I’d like to make a quick comment on a recent post by Nick Rowe (H/T Robert Murphy) on the topic, just to clarify what Hayek and other Austrians actually have in mind. Near the beginning, Rowe writes,
Hayek assumed that newly-printed money is injected via the credit market, where it pushes down the market rate of interest relative to the natural rate of interest, and this causes people’s plans and expectations to be mutually inconsistent, and this causes an unsustainable change in the time-structure of production.
But Hayek’s assumption is obviously usually wrong.
My first reaction was, “No, Rowe is obviously wrong.” My second reaction was, “In part he’s right, but there’s something about this argument that is ignoring key aspects of the Mises–Hayek theory.” Because I haven’t been involved with the debate, it’s difficult for me to frame this within the context of said debate, but I think excessive focus on the Federal Reserve (which could be the fault of any [or both] side[s]) is drawing attention away from what makes Hayek’s assumption “obviously usually right.”
When the Fed injects money, Rowe is right that it can do so through various avenues. It can buy U.S. Treasuries through open market operations, both from banks holding these assets or from the government proper (less likely?), or it can control base money through short-term interest rates, et cetera. But, the Fed, in the role of credit expansion specifically, is really a “minor player,” in that most of the credit expansion comes as a result of private bank lending — this being said, the Fed is a “major player” in that it shapes the banking industry and decides the extent of credit expansion (i.e. if Selgin’s banking model in the Theory of Free Banking is correct, credit would be much more restricted in a competitive banking system). Hayek, in “Monetary Theory and the Trade Cycle” (e.g. p. 77 [in the Mises Institute’s hardback edition of Prices and Production and Other Works]), explicitly recognizes the role of private banks (the “existing credit organization”) in perpetuating credit expansion.
So, when Hayek is talking about the “inconsistency of plans and expectations,” in the context of the business cycle, the credit injections specific to Fed action are quite limited relative to the participation of private market financial firms. Although Rowe told me he doesn’t get Hayek’s theory, the last few paragraphs of his post say otherwise — what matters is the effect of base money on the extent of private market credit expansion.
To make my point clearer, let’s reformulate my argument to directly respond to the following claim by Rowe,
If Austrian economists are right to insist that it really really matters where the new money is injected into the economy, then Hayek was making a very special assumption, one that is nearly always empirically false, and false in a way that matters a lot, and so Hayek’s analysis is mostly irrelevant.
What Rowe may not realize is that the “special assumption” is actually his: the Fed is not the only organization/firm that injects new money into the economy. Banks also create money through loan over-extension, or credit expansion, “in a way that matters a lot,” making Hayek’s analysis mostly relevant. If you want some empirical evidence,