EconTalk Podcast

Here is a link to an EconTalk podcast by Larry White and Russ Roberts in which they discuss business cycles, money, and Hayek. I found two sections of the podcast particularly lucid and perspicacious:

1. The central bank's role in creating bubbles

and

2. The importance of the velocity of money

In the absence of a central bank, the interest rate serves to balance the amount of savings and investment in an economy. During times of innovation, for example, entrepreneurs seeking funds for new investment opportunities will bid up the interest rate, ensuring only those new projects that are forecasted to be the most profitable get undertaken. In addition, the higher interest rate redirects savings from the least profitable, older investment opportunities to the most profitable, new opportunities. The limited nature of real resources and savings renders this reallocation essential.

When a central bank enters the picture, the automatic interest rate rise that occurs when new entrepreneurs start competing for finite savings is impeded. The central bank may be slow to raise interest rates, accommodating both the least profitable, older investment opportunities, and the most profitable, new opportunities. Larry White points out that this creates the illusion that there are more savings than there actually are, leading to overinvestment. Prices begin to rise as more and more firms financed by the cheap credit bid for scarce inputs. Leaving interest rates low accelerates this inflationary process, so the central bank will likely raise interest rates - cutting the supply of cheap funding and spelling doom for many borrowers. This kind of overinvestment bubble exaggerates a genuine innovation boom, and points to the role central banks play in perpetuating this type of bubble.

In another section of the podcast, Larry and Russ discuss the importance of the velocity of money. They begin with the equation of exchange MV=PT, which is essentially an identity between total spending and total income. The "V" in the equation is the velocity of money, or the rate at which money is changing hands. What I found interesting is how Roberts framed "V" as a measure of the general psychology in the economy, and in particular, expectations about the future. When people are unsure about future economic conditions, they tend to hold onto their money and spend less until the future becomes clearer.

We are seeing this in the economy today - there has been an enormous increase in M, but since V is so low, the increase in M has not had the predicted effect. However, the efficacy of increasing M to spark recovery is undermined by the difficulty in measuring V. If we do not have an accurate measure of V, there is no way to know how much M should be increased for the desired effect. Thus, the next best solution is to strive to stabilize V. In other words, stabilize people's expectations about the future. This includes expectations regarding inflation, tax conditions, and the regulatory environment. None of these areas are at all clear in the current climate, leading to the current difficulties jumpstarting the economy with traditional monetary and fiscal policy. For any hope of a recovery, stable policies should be put in place in order to anchor expectations about the future.