In June, economist Steven Horwitz, a professor of economics at Ball State University and a senior affiliated scholar with the Mercatus Center at George Mason University, passed away after a yearslong battle with cancer. Dr. Horwitz was a staunch supporter of individual freedom and a beloved friend and mentor to many.
While Horwitz wrote on topics ranging from disaster relief to family economics, for both academic and popular audiences, he also wrote prolifically on monetary economics and business cycles. Horwitz was one of a small number of macroeconomists to be influenced by the Austrian school of economics associated with Ludwig von Mises and F. A. Hayek. Austrian macroeconomics emphasizes the role central banks play in generating credit-fueled bubbles. Although Horwitz accepted major tenets of what is commonly called Austrian business cycle theory (ABCT), he also embraced insights from other macroeconomic schools of thought. Horwitz’s nuanced approach and rejection of dogma made him one of the best macroeconomists to come from the Austrian tradition.
Austrian Business Cycle Theory in a Nutshell
ABCT claims there are two ways for an economy to expand. The first way is for the public to save more so banks have more funds to lend out to profit-seeking companies. The second way is for a central bank to create excess money, which sets a business cycle into motion.
When a central bank creates too much money, the surplus of money initially causes interest rates to fall lower than they otherwise would, prompting investment in projects that would otherwise not take place. Consumers also save less because they earn less from the interest on their savings. While the economy initially experiences a boom period because of the increased investment, the boom turns to bust as there are not sufficient savings to fund these projects to completion. The economy then goes into a recession, a decline in economic activity, as both investment and consumption fall.
Many Austrian economists have argued the Federal Reserve created too much money in the 1920s, setting the stage for the Great Depression, and then again in the mid-2000s, leading to the Great Recession. Although Horwitz believed that ABCT explained the causes of these downturns, he also cautioned that ABCT could not explain their severity or duration. For example, while he believed that expansionary monetary policy (too much money) caused the 1920s boom, he also maintained that the subsequent monetary contraction (too little money) of the early 1930s is what turned a recession into the Great Depression.
On this point, he agreed with the economists Milton Friedman and Anna Schwartz, who came from the monetarist school of thought, which posits that business cycles are mostly determined by changes in the money supply. Further, he disagreed with some fellow members of the Austrian school such as Murray Rothbard, who argued that painful deflation is the only solution to recessions.
Avoiding Monetary Disequilibrium
To understand why Horwitz agreed with this monetarist point, we can look at his synthesis of ABCT and the notion of “monetary disequilibrium”—instances where the supply of money does not equal the public’s demand for money. On one hand, if a central bank supplies too much money, people will spend their excess cash balances, causing inflation to rise. When that happens, the central bank should reduce money growth.
On the other hand, if a central bank provides too little money, people restrict their purchases to build up their cash balances. Because this occurs across the economy, the aggregate result is a recession. There are two ways to fix this problem: either let prices fall or expand the money supply. If prices could quickly adjust downward, then the recession could be relatively brief because prices would eventually reach a new equilibrium in which people would be willing to purchase more. However, empirically, prices (wages, in particular) can be slow to adjust downward. Thus, recessions can be prolonged and marked by periods of high unemployment. For this reason, Horwitz agreed with monetarists, as well as most mainstream economists, that central banks should increase the money supply in response to a recession.
For Horwitz, the goal of monetary policy should be to produce enough money to satisfy the public’s demand for money, but not more (i.e., achieve monetary equilibrium). How can an economy achieve monetary equilibrium, though? In his book “Microfoundations and Macroeconomics,” Horwitz argued that a “free banking” regime, where there is no central bank and all money is privately issued, would actually be the best system in avoiding monetary disequilibria. His argument was that while a central bank must collect vast amounts of data to determine the public’s demand for money, profit-maximizing private banks will automatically adjust the money supply in response to the public’s demand.
Recognizing that free banking is a radical and politically infeasible reform, he argued that nominal GDP targeting, stabilizing the sum of total spending in the economy, is probably the most practical option to achieve this goal. A nominal GDP targeting regime allows inflation to rise in response to recessions to counteract the “bad” deflation associated with a contracting economy, but it also allows for prices to fall in response to increasing productivity.
Over the years, many economists across the ideological spectrum, including Friedman and Paul Krugman, have sharply criticized Austrian macroeconomics, in large part due to the Rothbardian view that a monetary expansion should always be avoided. By contrast, Steven Horwitz offered a more sophisticated approach to Austrian macroeconomics, worthy of consideration by the economics mainstream.