Conceptualizing Price Distortions

If the real world is always in disequilibrium, meaning most (or, all) prices are never their equilibrium values, how can we give meaning to concept of price distortions? Specifically, how does the “transmission mechanism,” so to speak, of the Mises–Hayek theory of intertemporal discoordination work, if prices are always, in a sense, distorted? Mises and Hayek placed emphasis on the concept of relative prices, to draw attention to differences in the movement of prices of goods belonging to different stages of production (on aggregate, we can talk about the relative price of producers’ goods to consumers’ goods). To give meaning to their theory in a world of disequilibrium, we should also emphasize the concept of profit and loss. Indeed, what we typically refer to as a price distortion may be better termed a distortion of profit.

In equilibrium, prices perfectly reflect the goods’ opportunity costs, and the market process is irrelevant, because all goods are already perfectly allocated — this world is changeless, since change would change the equilibrium value of the goods in question. It follows that in the real world, where the market process is, by virtue of experience, always in a state of change, prices do not perfectly reflect goods’ opportunity cost. Does this imply that these prices are “distorted,” whether it be as a result of government intervention or an outcome of the kaleidoscopic market process? In the very narrow sense of disequilibrium, sure, but I don’t think what most people have in mind when they talk of price distortions.

In a world of non-equilibrium prices, how do economic agents coordinate? To explain this, economists of the inter-war era, including Ludwig von Mises and Frank H. Knight, looked to profit and loss. If we assume, for the sake of simplicity, that all equilibria are perfectly competitive, profit and loss can only exist in a world of disequilibrium. Profits are earned by exploiting price differentials, and losses accrue by poorly estimating price differentials. These two related phenomena make up one of the market process’ most important feedback mechanisms. Profits are signals for other entrepreneurs to allocate their capital towards the production of output where profits are relatively high, while losses are a signal of overinvestment. Losses and profits also force the redistribution of capital from entrepreneurs who preform poorly to those who do well, and this process of redistribution continues perpetually, meaning it’s receptive to the fact that entrepreneurial success, probably, has as much to do with luck as it does with skill.

Within the context of profit and loss, the way I conceptualize non-distorted market prices is to look at possible prices as a range. This range is bounded by profit and loss, such that a highly inaccurate price will bring either extreme profit or extreme loss, pushing the price in the opposite direction as entrepreneurs react. In The Market as an Economic Process, Ludwig Lachmann urges us to look at both sides of the coin when emphasizing that all coordinating forces can also cause discoordination, and vice versa. For example, an entrepreneur who is seeking to exploit the profitability of a certain market will throw off other entrepreneurs who seek the same end, if the degree of future competition in that market is not well predicted. This is how I look at, what we can call, market bounded prices, where prices in disequilibrium implies some degree of discoordination, but at the same time the profits and losses which stem from disequilibrated prices help coordinate market agents.

When thinking of the distortion necessary to bring about sustained intertemporal discoordination, it may be easier to think about it in terms of profit and loss — or, in terms of constrained price ranges.

Suppose that some hypothetical, advanced market economy enjoys a banking system where there is a single currency. Individual banks are not allowed to issue their own banknotes, but must acquire them from official mints, controlled either by some government or by a central bank. The lack of competitive currencies eliminates an important disciplining mechanism, which is the constraint private banknotes place on the banks themselves (where excess notes are ultimately returned to the bank for redemption, either for some metallic money or for some other backing asset). This lack of a disciplining mechanism makes fiduciary over-issue (the supply of inside money beyond the demand for it) not only more likely, but it also lifts the constraints on the extent of the over-issue, such that the supply of money can exceed the demand for it for a significantly longer period of time and at a much greater volume.

According to Austrian capital theory, since money is non-neutral, new money will impact some prices more and sooner than others, implying that the social distribution of new money is unequal. Consumer credit complicates our analysis a little, so for the sake of simplicity we’ll assume it to be irrelevant. Banks typically issue new money through the loanable funds market, implying that people borrow it — new money is created during the process of the intermediation of savings. If the increase in the supply of money is met by an increase in the demand for money, we can assume that all new loaned money represents social savings. In the case of a fiduciary over-issue, there is some fraction of total new money that does not correspond to savings, causing intertemporal discoordination. This is because money lent through the loanable funds market, on average, is invested, meaning it targets a specific set of goods: capital goods.

We can interpret Austrian capital theory as a theory of the optimal intertemporal distribution of capital goods (all goods which are not consumers’ goods; usually, original factors of production [land, labor, et cetera] are not included, but for simplicity’s sake I do). To help form of an idea of what Austrians have in mind, imagine production to take over a series of stages. The last stage, which provides the final consumers’ good, requires certain inputs, and the production of these inputs make up the second stage. To manufacture these inputs, in turn, these firms require other inputs, and the production of these makes up the third stage. This continues until the earliest stage, whose inputs are original factors of production. Reality is a bit more complicated, but this abstract model helps capture what Austrians have in mind. The length of the structure of production, that is the number of stages, is determined by social time preference, or the ratio between saving and consumption. The volume of production within a given structure, though, is determined by the capital stock (the greater the capital stock, the more you can produce).

Money is relevant to the intertemporal distribution of capital goods, because it’s money prices, and profit and loss, which guides the allocation of goods over time. Assume all new money is lent to entrepreneurs. A fall in consumption lowers the price of consumers’ goods, increasing the relative price of labor in those industries. As a result, these firms increase their demand for labor saving machinery, raising the prices of these capital goods. An increase in savings will allow entrepreneurs to borrow these and invest them in the production of this machinery, which in turn will increase the demand for the inputs required to produce this machinery, and this continues, theoretically, until the rate of profit in each stage is equalized. In a world of disequilibrium there will always be discoordination, but it should be randomly distributed, and profit signals will help constrain the degree of discoordination.

The problem of an excess supply of money, then, is that it will raise the profitability of manufacturing capital goods, and therefore alter the structure of production, without simultaneously increasing the stock of savings. A conflict between consumption and investment is created. Within the context of bounded market prices, what excess money creation does is change the range of possible market prices. As long as new credit increases at an accelerating rate (which fits with the data on credit creation preceding real world demand crises), these distortions of prices, and therefore profit and loss, will be sustained. In other words, the distribution of error is no longer non-random, but guided by distorted signals. This is why Austrians (borrowing from Murray Rothbard’s America’s Great Depression) call attention to the “cluster of errors,” rather than entrepreneurial error itself. The distinction between random and non-random error helps understand how Austrians interpret the phenomena of the demand-driven business cycle.

Illustrating this process with a Hayekian triangle and a production possibilities curve may help,

Output Combinations and the Hayekian Triangle

I ≡ investment; OC ≡ consumers’ goods; OP ≡ producers’ (capital) goods. In equilibrium, there is a specific point on the production possibilities curve (PPC) the economy will be in. Given how the axes are termed, the slope of the tangent of the equilibrium point will be equal to –PP/PC (the relative price of producers’ goods). We can see how an increase in savings and investment leads to a lengthening of the structure of production (represented by the triangle), as goods originally allocated in stages nearer the consumer are re-allocated towards earlier stages of production. This entails a movement down the PPC, as relative prices change. Therefore, an oversupply of money will cause this save movement, but without a change in social time preference, such that when relative prices re-adjust, a movement back to the original point must occur. This movement back to the original point is the depression (and recovery), and is aggravated because of the sudden collapse of demand — the distribution of profits and losses change, and those earning sustained profits during the boom are now subject to the losses that come with prices returning to the bounded range that better reflects the underlying opportunity costs of the goods in question.

Austrian business cycle theory — what I call the Mises–Hayek theory of intertemporal discoordination — is usually modeled with microeconomic tools which are built around the concept of equilibrium. This is done, because it’s easier. But, it’s fundamentally a disequilibrium process. It can only happen in a world where there exists profit and loss, and changes in prices. It entails a shift from a random distribution of losses to a non-random distribution of losses, caused by the distortion of prices that comes with an over-issue of money. Conceptualizing it in a world of disequilibrium only requires being creative with how we interpret the models used to illustrate the process.

17 thoughts on “Conceptualizing Price Distortions

  1. Rob Rawlings

    I agree with this 100%

    “But, it’s fundamentally a disequilibrium process. It can only happen in a
    world where there exists profit and loss, and changes in prices. It
    entails a shift from a random distribution of losses to a non-random
    distribution of losses, caused by the distortion of prices that comes
    with an over-issue of money.”

    But would disagree with this:

    “Banks typically issue new money through the loanable funds market,
    implying that people borrow it — new money is created during the process
    of the intermediation of savings”

    In a modern banking system new money is introduced by the CB purchasing assets with newly created money. This new money is then deposited by the recipients in banks who will then have additional reserves to lend out (sometimes the CB buys the assets direct from the bank but its still the purchase and not any subsequent loans that create the new money).

    This may sound like a quibble but I think it important in understanding the mechanism by which interest rates end up being too low. Its only secondarily that the banks , finding themselves with more reserves, lower the lending rate to clear the market. Its initially that individuals holding more money in aggregate than before will lend more to banks which will cause interest rates to fall. Interestingly, individuals lending to banks at lower interest rates are also making “clusters of errors”. If they knew that the new money would lead to inflation they would not lend at such low rates and the boom would never get started.

    1. JCatalan

      I agree with your second point, but I don’t think private money creation is always restricted by the willingness of the central bank to expand bank reserves through open market purchases. The amount of money a bank can loan is restricted by the asset side of its balance sheet. If a boom leads to rising asset prices, then banks will be able to take advantage of this by loaning even more capital (because rising asset prices means they now need a smaller quantity of assets to cover their capital reserve restrictions). I talk about this a little in this post.

      If there is no clearing mechanism, I think an over-supply of money can occur endogenously (without the central bank conducting open market operations), especially when the banking system is structured. Consider the recent recession. Investment banks bought large volumes of mortgage debt from commercial loan originators, giving loan originators the room to lend even more. But, this is what led to rising home prices, and therefore a bubble in mortgage debt, which allowed investment banks to invest a greater volume of capital, even if their stock of assets remained the same. In other words, there was a sort of vicious circle that fed loan origination, which in turn fed rising asset prices, which led to more structured debt being created.

      I think your point on depositors is a good one. This is essentially what happened with wholesale credit. Wholesale depositors made the boom much worse than it would have been otherwise, because the volume of short-term credit available to banks would have been much more restricted.

    2. Roman P.

      I have to side with Jonathan here, creation of money has nothing to do with open market operations of the central banks. Though, it’s not that there is something on the asset side of the balance sheet that definitely restricts how many loans a bank can make (and how much money it can create); a loan could always be made at some profit margin. The banks are unconstrained by the quantity of their reserves or the amount of money on their deposit accounts (Fullwiller 2013). This result is not very intuitive but it becomes very clear once you walk through the accounting. I highly recommend Fullwiller’s article for this purpose.

      1. Rob Rawlings

        Its true that when a CB targets a given overnight rate that a private bank may make a loan in advance of having reserves knowing that it can obtain them later by borrowing them. However underlying this system is a commitment by the CB to use OMO to expand the money supply to generate these reserves if needed.

        So even with ‘endogenous money’ its still asset buying that creates new base money.

      2. JCatalan

        Right, the profitability of a loan includes some probability of risk. All banks keep capital reserves, therefore the extent of money creation depends on a bank’s capital reserve.

  2. Bart

    Because of CB’s money injection into the system there arises a dicrepancy between an amount of savings which would be available if it wasn’t for artificial money creation and amount of savings which is available. This is the cause of a lower than natural interest rate which subsequently makes an illusion that people want to consume more than in fact they do. It’s a cause why some ventures must fail (no demand for their products). Do I understand it right?

    1. JCatalan

      Well, if we focus on the interest rate, a lower interest signals that people are presently consuming less. I actually think “consuming less” is a misnomer. In period of time ‘t,’ sure, that’s what it means. But at ‘t+n’ the ratio of savings to consumption can remain the same, but people can be consuming more (it’s just that the price of consumers’ goods falls). But, I don’t like focusing on the interest rate. I think it creates too much debate on which theory of interest is right, and ultimately I think that’s mostly irrelevant. I like to focus on relative price changes, and therefore changes in profit and loss.

  3. Beefcake the Mighty

    “According to Austrian capital theory, since money is non-neutral, new money will impact some prices more and sooner than others”

    This is actually a non-sequiter; you seem to be confusing Cantillon effects with non-neutrality. However, the real problem is that the notion of non-neutrality is totally at odds with this statement, pretty standard in the conventional accounts of ABCT:

    “The problem of an excess supply of money, then, is that it will raise the profitability of manufacturing capital goods, and therefore alter the structure of production, without simultaneously increasing the stock of savings.”

    1. JCatalan

      Ugh, coming out of the woodwork to give another one of your “enlightening” sermons?

      1. I don’t mean money neutrality in the Hayekian (1931) sense, where it’s one consistent with intertemporal coordination (such that relative price changes can occur in an environment of neutral money). But, in the more traditional sense, where a change in the price level doesn’t affect the allocation of goods;

      2. Therefore, money non-neutrality is not inconsistent with what you excerpt, since changes in the supply of and demand for money will affect output. Maybe some monetary equilibrium theorists believe that ultimately the original equilibrium will be restored, but there’s no reason why that can be dropped in favor of the more indeterminate market process.

      1. Beefcake the Mighty

        There really is no reason for you to be so impressed with your own cleverness. No one said anything about Hayekian neutrality here. At any rate, your points 1 & 2 are inconsistent with one another as they conflate short-term and long-term effects. NO ONE believes in short-term neutrality, this is not a uniquely Austrian position.
        The issue does not really concern ME theorists as such, although they’re particularly bad offenders. Either monetary changes induce permanent changes in allocations, or they don’t. The latter case is the essence of (long-term) monetary neutrality and is also the essence of conventional ABCT. If you believe in conventional ABCT, you believe in (long-term) monetary neutrality. Which is probably why Austrians have utterly failed at persuading neoclassicists about its viability, as neoclassicists also accept monetary neutrality and instead (rightfully) dismiss the Austrian claims about the mechanism (namely entrepreneurial ignorance re. central bank actions).

        1. JCatalan

          I’m sorry, but I don’t understand your point. I understand what you write, but I don’t see how any of it is relevant, and I don’t see how your point on “inconsistency” is proven by anything that follows in your comment. All I see is you talk about long-run money neutrality, as if this is a major concern of my post (when I’ve always assumed long-run non-neutrality, and long-run non-neutrality is not inconsistent with monetary equilibrium or ABCT). The best I can gather is that you’re trying to be a pedant.

          1. Beefcake the Mighty

            Well, there is definitely some progress then. You are explicitly admitting here that you accept long-term monetary neutrality, which you have previously claimed to reject. As I’ve always said: you are an Austro-Walrasian.

  4. tr00pa

    Amazing article, thank you. Ill probably have to read it few more times since im not a native speaker. Anyways, for now, I have a small question regarding the “triangle”.The graph shows different combinations of Qc and Qp. Is that line representing total production capabilities of both groups of goods, or is it just an illustration how social preferences are changed, thereby changing production structure?


    1. JCatalan

      The model on the right, the production possibilities curve, plots all possible output combinations with some given quantity of inputs. So, let’s say that we can either produce 1,000,000 consumers’ goods or 1,000,000 producers’ goods, and then to produce 1 more of one or the other we have to sacrifice one unit of the opposite kind of good (e.g. to produce 1,000,001 consumers’ goods, you can only produce 999,999 producers’ goods). So, in the context of the above diagram, it basically represents social time preference, where to increase the stock of producers’ goods we sacrifice some of our consumption (by decreasing the stock of consumers’ goods).

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