The Mises-Hayek business cycle theory, fiat currenciesand open economies

Nicolas Cachanosky

# Springer Science+Business Media, LLC 2012

Abstract This paper extends the Mises-Hayek business cycle theory to open econ-omies with fiat currencies. I explore: (1) the problem of domestic versus internationalmonetary policy with fiat currencies in an international setting. (2) How the feedbackeffects between central banks in the context of an expansionary monetary contributesto extend and transmit a Mises-Hayek business cycle from big economies to smallfinancially integrated economies. I find that a lengthening of the period of productionis not the only effect produced on the capital structure, but also a misallocation ofcapital goods between the production of tradable and non-tradable goods and servicesand that business cycles can become more severe when there are open economieswith fiat currencies.

Keywords Austrian business cycle theory . Fiat currencies . Exchange rate .

International business cycle

JEL Codes B53 . E32 . E58 . F44

1 Introduction

The 2008 Financial Crisis imposed a challenge to macroeconomics and businesscycle theories. Some scholars suggest that macroeconomics in general, and RBCmodels in particular, fall short in understanding the recent financial crisis; “macro-economics is on the wrong track,” has been argued (Caballero 2010; Ohanian 2010;White 2009). In addition, the 2008 Financial Crisis also presents features of interna-tional transmissions of business cycles. One of the important features in an interna-tional context is the role played by the foreign exchange rates. As described by Calvoand Mishkin (2003), different exchange rates can absorb different shocks. For

Rev Austrian EconDOI 10.1007/s11138-012-0188-2

N. Cachanosky (*)Department of Economics, Suffolk University, Boston, MA, USAe-mail: ncachanosky@suffolk.edu

instance, a fixed exchange rate is preferable in the presence of a monetary shock and afloating exchange rate in the case of a real shock. Empirical studies try to identify ifbusiness cycle behaves differently across countries with different exchange rateregime with inconclusive evidence (Canova 2005; Ehrmann and Fratzscher 2009;di Giovanni and Shambaugh 2008).

To explain what went wrong in the 2008 Financial Crisis some authors argue thatthe problem is to be found in a monetary policy that kept interest rates too low for toolong (Diamond and Rajan 2009a; Dowd 2009; McKinnon 2010; Meltzer 2009;O’Driscoll 2011; Schwartz 2009; J. B. Taylor 2009).1 Other authors have gone furtherand more specifically sustain that the 2008 Financial Crisis is consistent with anAustrian interpretation (Borio and Disyatat 2011; Diamond and Rajan 2009b; Garrison2009; Lal 2010; Leijonhufvud 2009a; O’Driscoll 2009; White 2008; Young 2011).

The Mises-Hayek business cycle theory can contribute to explain what wentwrong with the 2008 Financial Crisis. This theory, however, assumes, as was relevantat the time of its development, a classic gold standard. Hayek (1931, pp. 109-112)argues that his analysis holds in either a closed or open economies. However, Hayekstates that in his exposition changes in the quantity of money are meant to happen inone or several countries that “form part of a larger economic unit.”2 Hummel (1979,p. 50) maintains that “Austrian economists have for the most part developed theirbusiness cycle theory within the context of a closed economy and have rarely appliedit to an international setting.” Wagner (1999, p. 68) sustains that an updated presen-tation of the Mises-Hayek business cycle theory should account for the presence offiat currencies. To account for fiat money rather than gold standard moves the theoryfrom a context of a closed economy to that of open economies with foreign exchangerates. As such, links between so called “Austrian” and “mainstream” business cycletheories can be built.

Only recently, Cowen (1997, chapter 3), Hoffmann (2010), Hoffmann and Schnabl(2011a, 2011b) and Ritchie (2005), consider the case of Mises-Hayek theory in openeconomies. However, further work is needed for this theory to communicate andcontribute with other business cycle theories. For instance, in areas related to (1)international monetary policy, (2) the behavior of economic variables across countrieswith different exchange rates and (3) changes in the relative prices between non-tradable and tradable goods which and the literature on the purchasing power parity(Burstein et al. 2006; Engel 1999; Rogoff 2009). The attention the Mises-Hayektheory pays to the effects of monetary policy on the capital structure can help tounderstand why on some occasions business cycles across countries with differentexchange rates look alike and also to expect particular movements in the relativeprices of nontradable to tradable goods.

The Section 1 of this essay deals with central banks interaction and the problem ofdomestic versus international monetary policy. The Section 2 deals with the effects inthe small open economies when a big economy follows an expansionary monetarypolicy. Both, the interest rate and the foreign exchange rate play a role in transmitting

1 See also Oppers (2002).2 See also Haberler (1937, p. 68): “A systematic account of the international aspect of the business cycle onthe basis of the theory hitherto under consideration [the Mises-Hayek business cycle theory] has never beenattempted.”

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distortions to the capital structure of small open economies. The Section 3 reconsidersthe position by Cowen (1997) and Ritchie (2005) that business cycles of the Mises-Hayek type become less severe in the context of open economies with respect to aclosed economy.

2 The international monetary regime and open economies

Unless otherwise mentioned, I will assume that the central bank in a large economy(the center) decides to follow an expansionary monetary policy and there is aperiphery formed by small economies financially integrated to the center that reactsto the center’s policy. The currency issued by the center is used as the internationalmonetary reserve and each country uses its own currency for domestic exchanges.

2.1 Interaction between central banks

The original exposition of the Mises-Hayek theory assumes classic gold standard,therefore the expansionary policy of any central bank results in a drain of its owncountry’s reserves. This works as a market correction mechanism when the monetarypolicy has become too loose. The loss of reserves through adverse clearing indicatesthat the monetary policy should be revised.

In the case of a commodity standard, since there is only one commodity money forall the economies, central banks issue money substitutes in the form of banknotes.Modern central banks issue fiat currencies. In the case of a commodity standard, sinceall banknotes are convertible to the same commodity, there is no exchange ratebetween them, but parity. Fiat currencies do have exchange rates between thembecause they are different currencies.3

There is a substantial difference between classic gold standard and fiat money. Inthe former, central banks cannot issue gold, only convertible banknotes. In the latter,the central bank that issues an international money reserve is in a position as if it wereable to print gold in the case of classic gold standard. Therefore, the relationshipbetween central banks is different when there is a classic gold standard and whenthere are fiat currencies. Unlike the case of gold standard, where a central bank cannotfollow a loose monetary policy without facing adverse clearing as long as othercentral bank redeem, rather than hold, foreign banknotes, under an international fiat

3 It is common to find in the literature references to a fix exchange rate, or pegged exchange rates, betweenbanknotes and gold under a gold standard regime. See, for instance, Eichengreen and Temin (2000, p. 187)and Obstfeld and Rogoff (1996, p. 568). This terminology is misleading. Under a classic gold standardregime banks issue IOUs convertible to a commodity money, but they are not money proper. There is nopegging, for instance, between a cheque and its monetary value. Similarly, since all banknotes areconvertible to the same commodity money, there is parity between different banknotes, and not exchangerates. To see an exchange rate between these two banknotes is no different than seeing an exchange ratebetween two cheques issued under the same currency but by different issuers. The exchange ratio betweenthese cheques does not depend on their demand and supply, but on their respective denominations. A goldexchange standard where the conversion rate for each banknote can be changed by the issuer is a substantialdifferent monetary institution.

For a discussion on the evolution of monetary regime see McKinnon (1993) and L. H. White (1989,chapter 7).

The M-H business cycle theory, fiat currencies and open economies

monetary regime one central bank has more room for monetary expansion if othercentral banks are willing to accept increasing amounts of the center’s currency asreserves. As long as the countries in the periphery are willing to peg their currenciesand absorb the center’s currency as reserves, the center can keep expanding its moneysupply without facing foreign exchange depreciation. For a similar situation to occurunder a gold standard other central banks need to hold the convertible notes theyreceive and do not redeem foreign banknotes.

Absent the adverse clearing that characterizes the classic gold standard, centralbanks need to find a substitute signal to guide monetary policy. Under a classic goldstandard, a central bank can have good knowledge of the amount of gold in reserves.A monetary policy under fiat currencies needs to rely on something else. For instance,a central bank that follows a Friedman rule such that the price level remains stableneeds to know how output and money velocity changes.4 But finding a goodsubstitute poses important challenges. For instance:

1. What market behavior should be observed?2. How are these observations going to be measured?3. How should they be interpreted?

Inaccuracies or errors in any one of these aspects can result in an inefficientmonetary policy.5

There does not seem to be a strong agreement on what indicators a central bankshould follow. For instance, should the focus be in unemployment? Or should it be onthe price level? If so, should the central bank follow a CPI or the GDP deflator? Orare interest rates a better variable? In that case, should short-term interest rates, long-term interest rates or a Taylor rule be the guide? Or does nominal income (i.e. NGDP)provide a better indicator? If so, should the target be a constant NGDP or a growingNGDP? This situation is not trivial. To choose the wrong indicator, measure it orinterpret it incorrectly can result in the wrong monetary policy.

The relationship between central banks through foreign exchange policy becomesrelevant to understand how economic indicators react in the presence of an expansivemonetary policy. If the central bank in the center goes into credit expansion, then thecentral banks in the periphery have to choose between allowing their currencies toappreciate or following the monetary policy of the major central bank and stabilizingthe exchange rate by pegging their currencies. For instance, according to Eichengreen(2004), the United States “has been able to run persistent current account deficitswithout seeing the dollar fall significantly against the currencies of the peripherybecause the latter are concerned to preserve their position in the U.S. market. Thisprompts countries in the periphery to intervene with purchases of dollars in order tokeep their exchange rates from appreciating.” Similarly, Taylor (2009, p. 8) asks“whether the low interest rates [before the 2008 Financial Crisis] at other centralbanks were influenced by the decisions in the United States or represented aninteraction among central banks that caused the global short-term interest rates to

4 Adverse clearing is not free of innacuracies or potential shortcomings. If the clearing among central banksis not fluid enough, then the changes in the stock of reserves occur with a lag that may affect the centralbank’s reaction.5 Morgenstern (1950) offers an analysis of the accuracy problems in the measurement of economicindicators.

N. Cachanosky

be lower than they otherwise would have been.” Obstfeld et al. (2010) find thatduring the last decade there was an increase in the accumulation of reserves bymonetary authorities with respect to national output. In addition, Ahrend et al. (2008)show that those countries with persistent low interest rates, with respect to Taylor’srule, are highly correlated with increases in asset prices, especially in the housingmarket.

The existence of fiat currency opens the door to two issues that deserve attention.First, since there is more than one currency, the behavior of each central bank affectsthe decision of the other central banks. Of particular interest for the Mises-Hayekstory are the cases where the periphery decides to keep exchange rates stable,allowing the center to prolong the expansionary monetary policy. Second, absentthe mechanism of adverse clearing, a substitute indicator needs to be chosen. Thisdoes not only present the problem of deciding on a good substitute, but also thegeographical scope that the monetary authority must be concerned with. Should themonetary policy follow domestic or international indicators? If the monetary authorityignores international indicators then the monetary policy may become too expansionary.The problem is not, however, only to find a good substitute indicator, but no less forcentral banks to have the commitment to follow them. It is no solution to have a decentguide if it is not going to be observed. Ahrend et al. (2008) and Taylor (2009), forinstance, show that the Taylor rule was persistently violated.

2.2 Domestic versus international monetary policy

The presence of central banks brings to the table what Hayek (1937) identified as theproblem of monetary nationalism, the concern on part of monetary authorities fordomestic, rather than international, economic indicators. Along these lines, McKinnon(2010, p. 11) argues that “the Fed, with its orientation towards only domesticmonetary indicators,” ignored the international signals of unsound monetary policy.Monetary nationalism can result in central banks choosing the wrong economicindicators if government officials are more concerned with the performance ofdomestic variables.6

Absent the adverse clearing mechanism of the classic gold standard, the behaviorof the price level became a usual sign of when the economy is overheating due to anexcessive monetary policy. If the price level rises too much, then the monetaryauthority will have to increase interest rates to stop inflation. However, the anchoringof the domestic price level of tradable goods to international prices can drive themonetary policy off its course.

In an open economy that issues fiat money, inflation may become erratic ifthe economy is not big enough or if there is excess capacity in the rest of theworld (i.e. China and regions of Asia). This is Leijonhufvud (2007, 2009b) andWhite's (2006) argument of why price level stability is not sufficient to guaranteeeconomic stability. The monetary authority may think it is following a stable path bylooking at the domestic price level, when in actuality it is being too loose.7 Increasesin consumption are satisfied through imports and inflation is postponed, the foreign

6 On optimal currency areas see Corsetti (2008), McKinnon (1963) and Mundell (1961).7 Naturally, the larger the economy the less relevant is this problem.

The M-H business cycle theory, fiat currencies and open economies

exchange rate policy of other central banks affects this feedback mechanism bynot allowing for currency appreciation and which cause the price of importgoods to rise; therefore, the central bank in the center does not feel the pressureto increase interest rates. Even if, eventually inflation effects will be present,the central bank is in the position to follow an expansionary monetary policy for alonger period of time if the price level reacts slower than adverse clearing under a classicgold standard.

The result of this interaction between central banks can produce a problemsimilar to the one that arises when there are periods of productivity gains. Byimporting goods and services from abroad, the domestic economy makes use offoreign productivity. In the presence of productivity gains, either the price levelof consumption goods fall, or the price level of the factors of production rise.The monetary authority cannot keep both price levels stable. However, if themonetary authority tries to keep the price level of consumer goods from falling,it needs to increase the money supply in order to offset the fall in prices. Aslong as this monetary expansion is carried through the financial markets, thenthere will be an increase in the supply credit and a relative fall in marketinterest rates. Selgin et al. (2011), for instance, argue that this was one of the issuesthat misled the Federal Reserve in the years prior to the 2008 Financial Crisis. This isan example of the price level being an inefficient indicator during periods of produc-tivity gains.8 As long as the periphery is in a position to supply goods at competitiveprices, the center’s central bank is in a position to continue with the expansivemonetary policy as inflation is postponed.

The interaction between central banks in the periphery and the excess capacity inthe international markets contribute, for instance, to the explanation of two importantcharacteristics of the 2008 Financial Crisis. First, that the Federal Reserve was able tokeep interest rates too low for too long in the years before the crisis.9 Second, that thesaving glut hypothesis was actually a credit glut problem originated by central banksexpansive monetary policy rather than excess of real savings. The positive saving gapin the rest of the world was compensated by a negative saving gap in the UnitedStates.10 It was not excess savings in the rest of the world what pushed interest ratesdown, but central banks in the periphery following the Federal Reserve’s lead on lowinterest rates policy.

Since central banks represent a regional-national monopoly, the problem of do-mestic versus international optimal monetary policy arises. If the political cycle ismore sensitive to the performance of domestic economic indicators, the mandate thatpolitical institutions put over the central bank may conflict with the internationaleffects of the monetary policy. To follow an indicator such as domestic inflation canbe misleading as long as the effects of a monetary policy that is too loose are not fullyreflected on domestic indicators. Therefore, the monetary policy in the center canhave effects on the periphery that go overlooked when the domestic performance isthe central bank’s objective.

8 For a more detailed exposition see Selgin (1996, chapter 7, 1997) and L. H. White (2007).9 See also Aglietta and Rzepkowski (2004).10 See Borio and Disyatat (2011), Hoffmann and Schnabl (2011b) and Taylor (2009).

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3 The effects on small open economies

The monetary expansion by the center affects the small open economies in the peripherythrough at least two channels, the interest rate and the foreign exchange rate. Since thecenter can affect the level of interest rates, the periphery undergoes the same effects thanthe center due to low interest rates. The financial markets in the periphery receive newfunds from the center that can be extended as new loans to the market to increaseconsumption and investment. However, the foreign exchange policy also affects howthe monetary shock translates into distortions in the capital structure.

Even though all goods and services are tradable, the presence of a foreignexchange rate makes the difference between goods that are traded internationally(henceforth tradable) and goods that are traded domestically but not internationally(henceforth nontradable) relevant. In the context of open economies with fiat currencies,the Mises-Hayek business cycle theory also implies effects in the capital structurethrough the relative prices of nontradable to tradable goods.

3.1 The foreign exchange channel

The countries in the periphery can decide on different foreign exchange policies; forexample, to have a free float regime, a managed float regime (i.e. a crawling peg), orto fix its exchange rate. I will focus on the cases of fixed and floating exchange rates.For each one of these cases we should consider what occurs from the point of view ofthe center and from the point of view of the periphery.

Let us first consider the case when the periphery pegs their exchange rates to thecenter, which is following an expansionary monetary policy. As Calvo and Reinhart(2002) point out, small and emerging economies that are sensitive to foreign ex-change volatility may experience a fear to float and decide to peg their currencies, orto intervene in the foreign exchange market to slow down currency appreciation.From the point of view of the center, the increase in consumption of tradable goodscan be satisfied with imports. But the increase in consumption of nontradable goodscan only be satisfied with domestic production. As a result the price of nontradablegoods (pNT) increases with respect to the price of tradable goods (pT). Consequently,the increase in imports results in an incentive to reallocate capital goods from theproduction of tradable goods to the production of nontradable goods.

From the point of view of the periphery, the opposite occurs. The increase inimports from the center is an increase in exports for the periphery. For the periphery,then, the increase in exports results in an incentive to reallocate resources from theproduction of nontradable goods to the production of tradable goods. The peripheryincreases its export dependency to the center. China, for instance, has recently usedoutput gaps to become a provider of tradable goods at competitive prices by stabi-lizing their exchange rate.

Eventually, output gaps will be eliminated, inflation expectations will increase,and the monetary authority in the center will in due course revise its monetary policyby increasing interest rates. At this point the dynamics reverse and the boom starts totransition into a bust.

If the periphery decides to let their foreign exchange rates float, then, from thepoint of view of the center, an expansion in money supply results in currency

The M-H business cycle theory, fiat currencies and open economies

depreciation. Imports become more expensive, but export industries become artifi-cially more competitive. Imports decrease and exports increase. In this case, theincentive is to reallocate capital goods from the production of nontradable goods tothe production of tradable goods. Now it is the center that increases its exportdependency. This occurs in addition to a lengthening of the structure of production.

From the point of view of the countries in the periphery, their currencies appreciate.For the periphery, imports become cheaper and exports become more expensive.Imports increase and exports decrease. In the periphery, then, there is an incentive toreallocate capital goods from the production of tradable goods to the production ofnontradable goods.

When the center revises its monetary policy, the inverse effects occur. From thepoint of view of the center, the currency appreciates, increasing imports and decreas-ing exports, inducing a reallocation of resources from the production of tradablegoods to the production of nontradable goods. From the point of view of theperiphery, the currency depreciates, increasing exports and decreasing imports. Thisstimulates a reallocation of resources from the production of nontradable goods to theproduction of tradable goods.

This suggests that the effects on the relative prices between nontradable (pNT) andtradable goods (pT) are asymmetric in the center and in the periphery and alsodepends on the exchange rate regime in place. Table 1 summarizes the effects onthe relative prices of nontradable to tradable goods.

The behavior described on the relative prices of nontradable and tradablegoods offers a resemblance to the problem raised by the rational expectationscritique of the Mises-Hayek business cycle theory. If the entrepreneurs expectthe change in relative prices to be temporary, then the increase in demand foreach sector would be met by increase in prices rather than in real resourceallocation. Just as a loose monetary policy should not fool the entrepreneur’srational expectations on interest rates, it should not do so in the behavior of therelative prices of nontradable and tradable goods as well. However, the debateshows that to assume homogeneous entrepreneurs with rational expectationsmay not be the proper approach to study business cycles.11

The role of the relative prices between nontradable and tradable goods has beenexplored in studies related to the law of one price and the purchasing power paritypuzzle. The purchasing power parity puzzle builds on the empirical findings that theeffects of a monetary shock on the real exchange rates take too long to disappear(Rogoff 1996, 2009).

It is important for this puzzle to differentiate between the price of nontradable andtradable goods (Balassa 1964; Samuelson 1964). If the price level of any givencountry is a weighted average of the price level of tradable and nontradable goods,a significant participation of the price level of nontradable goods can account for theslow rate the shock damps out as find in the empirical studies. Chari et al. (2002),Engel (1999) and Groen and Lombardelli (2004) find that the price of nontradablegoods does not have a significant participation in fluctuations of the real exchange

11 On the rational expectations critique see Barnett II and Block (2005; 2006), Block (2001), Callahan andHorwitz (2010), Caplan (1997), Carilli and Dempster (2001), Cowen (1997), Evans and Baxendale (2008),Garrison (1986), Salerno (1989), Tullock (1988, 1989) and Wagner (1999).

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rate, requiring the purchasing power parity puzzle to be explained just with prices oftradable goods. However, the distinction between a nontradable and a tradable price isnot so straight forward. For instance, any international tradable good has nontradabledelivery components included in the final price (a meal cooked with tradable com-ponents served in a nontradable restaurant). In addition, baskets of consumptiongoods used to measure price levels may not be equally defined between countries.Studies that give a closer look to these shortcomings find that the participation of theprice of nontradable goods can, in fact, be quite significant (Betts and Kehoe 2006;Burstein et al. 2006; Dotsey and Duarte 2008).12

Empirical data showing these asymmetric effects are not easy to obtain. First, themeasurement of tradable and nontradable prices is not straightforward as the literatureon the purchasing power parity puzzle shows. The results are very sensitive to what isbeing used as a proxy for tradable and nontradable price levels. Second, export pricesare not available for a number of countries. Third, the discussion in this paperassumes one center and a periphery that can be formed by a group of small countries.A country, however, can be in the periphery of two centers at the same time.13 Ireland,for instance, is part of the Euro zone, but its bigger export recipient is the UnitedStates. This means that the relative price between nontradable and tradable goods inIreland can be pushed in opposite directions at the same time. Still, some illustrativeresults on the asymmetric behavior of the relative price between nontradable andtradable goods can be shown.

Figure 1 depicts the quarterly evolution of relative prices between nontradable and

tradable goods pNTpT

� �for the United States and Mexico (floating exchange rate)

between 1995 and 2011. For the United States, tradable prices are represented byexport prices and the nontradable prices are represented by the CPI (SA). The plotshows an increase in pNT

pTfor the United States. Mexico, however, shows a decline in

pNTpT

. Even though CPI has both, nontradable and tradable components, it represents a

basket of goods less tradable than export prices do.14 Figure 2 shows the yearlyevolution of pNT

pTfor Panama between 1990 and 2010. For the case of Panama, pNT is

represented by the GDP deflator and pT by ECLAC’s export deflator. In this case, the

12 Another explanation for the purchasing power parity puzzle is given by Imbs et al. (2005). Given thatdisaggregated prices may adjust at an hetergoneous rate, the purchasing power parity puzzle can largely beexplained by aggregation bias. In other words, the non-neutral effects of a monetary shock do not stop at thenontradable and tradable level. This explanation, however, has found some negative reviews as beingmiscronstructed or not empirically relevant (Bergin et al. 2010; Chen and Engel 2005; Gadea and Mayoral2009).13 Also see Corsetti et al. (1999) who models competitive devaluations in a center-periophery frameworkwith three countries, one center and two in the periphery.14 Dissagregated data for CPI, which may be used to separate nontradable from tradable goods, is avaiableonly since 2000 in the BLS website.

Table 1 Effects on RelativePrices

Center Periphery

Fix exchange rate pNTpT

increases pNTpT

decreases

Floating exchange rate pNTpT

decreases pNTpT

increases

The M-H business cycle theory, fiat currencies and open economies

relative price of nontradable with respect to tradable goods decreases after 2002.Despite a slight increase in 2005, a sharp increase in the relative prices occurs since2008. Both countries, Mexico and Panama have the United States as the largestrecipient of their exports.

Fig. 1 Nontradable Relative Price (2001 Q10100). Source: Calculations with data from IMF-IFS.

Fig. 2 Nontradable Relative Price (20010100). Source: Calculations with data from ECLAC and WorldBanks WDI & GDF.

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In addition, in the United States, the CPI measures rent, not housing prices.According to the Bureau of Labor Statistics, the CPI measures the “value of shelterto owner-occupants as the amount they forgo by not renting out their homes.”15 Thehousing prices captured in the S&P Case-Shiller 20-City Home Price Index start toturn down in 2006. Therefore, the US CPI is adjusted to consider the housing bubble.To capture this effect, the evolution of the shelter component in the CPI is adjusted tofollow the growth rate of the Case-Shiller 20-City Home Price Index.16

The distinction between nontradable and tradable goods is relevant for tworeasons. First, it suggests specific movements in the relative price of nontradable totradable goods. Second, points to the possible outcome that an expansionary mone-tary policy absent domestic inflation can still result in asset bubbles in the nontradablesector. Since the increase in demand of nontradable goods cannot be satisfied throughimports, the relative price of nontradable goods rises with respect to the price oftradable goods as the supply of money increases. In other words, inflation takes placein nontradable goods sooner than it does in tradable goods (unless there are signif-icant output gaps in the nontradable goods industries). As long as this does notstrongly manifest into the inflation measures of the center, and since bubbles are hardto clearly identify, the monetary policy may fail to identify an inflationary monetarypolicy. For instance, the housing bubble that burst in 2008, which according toReinhart and Rogoff (2009, p. 207) was the biggest in magnitude and duration since1891, was not considered a signal strong enough to revise the monetary policy.

To have a rudimentary, but illustrative, approximation of the impact that housingprices would have had in the overall CPI, we can compare the adjusted US CPI usedin Fig. 1 with the official CPI. Table 2 shows the total and yearly growth rates of bothCPIs from December 2001 to December 2005 and from December 2001 to December2007. Figure 3 shows the quarterly evolution of both CPIs between 2001 and 2011.

The monetary expansion that is focus of the Mises-Hayek theory is mainlyconcerned with how the interest rates lengthen the structure of production. Thepresence of fiat currencies also implies that exchange rates affect the capital structurein tradable and nontradable goods industries. The effects that occur through these twochannels also share effects caused in the capital structure.

3.2 The Two channels and the capital structure

According to the standard theory of foreign exchange rates, if a country wants tominimize output volatility, it should follow a fixed exchange rate in the case of amonetary shock, and a flexible exchange rate in the case of a real shock (Calvo andMishkin 2003). In the case of a nominal shock in another country, an appreciation ordepreciation of the exchange rate would transmit the shock into the real sector byimpacting the nontradable and tradable industries differently. However, if there is areal shock, such as a productivity change, then a flexible exchange rate can accom-modate the relative prices changes between nontradable and tradable goods. Sinceprices are assumed to be sticky with respect to the foreign exchange rate, movements

15 http://www.bls.gov/cpi/cpiqa.htm#Question_2 [Access: 18-Jan-2012].16 I use the Case-Shiller 20-City Home Price Index quaterly values since March 2001.

The M-H business cycle theory, fiat currencies and open economies

in the foreign exchange rate can speed up the adjustment relative prices between thenontradable and tradable goods.

This means that the optimal foreign exchange policy depends on the kind of shockthe economy is facing, and since the shocks considered by the Mises-Hayek businesscycle theory are monetary shocks, the standard theory calls for a fixed exchange ratepolicy. What the Mises-Hayek business cycle theory can offer as a contribution aretwo insights as to how the capital structure in the nontradable and tradable goods isimpacted by exchange rates. These insights are the lengthening of the capital structureand the role played by heterogeneous capital goods.

By having an effect in both, interest rate levels and relative prices between non-tradable and tradable goods, the expansionary monetary policy affects the capitalstructure in two ways at the same time. Any reallocation between nontradable andtradable sectors in the center and periphery occurs parallel to an increase in round-aboutness. The changes between nontradable and tradable industries are also subjectto misallocation of heterogeneous and specific factors of production. The reallocation

Table 2 CPI Growth Rates

CPI-U (SA) [Official] CPI-U (SA) [Case-Shiller]

Periods Total Yearly Total Yearly

Dec-01 to Dec-05 11.5 % 2.8 % 34.2 % 7.6 %

Dec-01 to Dec-07 19.1 % 3.0 % 33.6 % 4.9 %

Sources: Calculations with data from the Bureau of Labor Statistics and the St. Louis FRED EconomicData.

Fig. 3 CPI, Original and Adjusted by Case-Shiller (Dec-20010100). Sources: Calculations with data fromthe Bureau of Labor Statistics and the St. Louis FRED Economic Data.

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of resources from one sector to another does not take place in the form of homoge-neous capital goods, but in the specific capital goods than can only be used inparticular production processes and in particular stages of production.

The capital structure can be thought of as a huge jigsaw puzzle, where the height ofthe puzzle can represent one dimension, like roundaboutness, and the width canrepresent the other dimension, the production share of nontradable goods to tradablegoods. An easy monetary policy in the center that lets interest rates to be too low fortoo long affects the jigsaw puzzles on these two dimensions. Even if one argues thatits effects on nontradable and tradable goods can be successfully isolated, theproblem of an increase of roundaboutness to an unsustainable level is still present.17

The relative behavior between the nontradable and tradable sectors depends on theelasticity of substitution between nontradable and tradable goods and between laborand capital. First, the elasticity of substitution between nontradable and tradablegoods define the direction the mobile factor of production (i.e. labor) will bereallocated. Second, the elasticity of substitution between labor and capital can affectthe relative growth in output of the nontradable and tradable sectors.

Obstfeld and Rogoff (1996, pp. 221-225) show that if there is a productivity shockin the tradable sector and elasticity of substitution in consumption between thenontradable and tradable sectors is equal to one, then labor will flow from thenontradable to the tradable sector. However, the movement of labor between thetwo sectors is undefined if elasticity of substitution is less than one. Labor allocationis pulled to nontradable and tradable industries through two effects. First, the increasein wages that follows the productivity shock also increases the demand for non-tradable goods, increasing the demand of labor as a factor of production. Second, theincrease in the relative price of the nontradable goods reduces its demand and alsoincreases the capital intensity of the nontradable industries. The first effect pulls laborto the nontradable sector, but the second effect pulls labor towards the tradable sector.The lower the elasticity of substitution between nontradable and tradable goods, themore likely labor will move to the nontradable rather than the tradable sector given aproductivity shock in the later industries.18 These effects should be considered sinceempirical findings show that elasticity of substitution between the two sectors can belower than one (Stockman and Tesar 1995).

The elasticity of substitution between capital and labor can also have an effect onthe relative performance of nontradable and tradable sectors. Empirical findings agreethat the Cobb-Douglas assumption of elasticity of substitution between these twofactors equal to one is untenable (Chirinko 2008). But elasticity of substitutionbetween capital and labor cannot only be less than one; it can also differ at theindustrial level. Assume, for instance, that the elasticity of substitution betweencapital and labor is higher in the nontradable sector than it is in the tradable sector.In the presence of a boom fostered by an expansionary monetary policy that incenti-vizes investment in capital intensive industries, the nontradable sector can react more

17 On capital theory see Horwitz (2000, chapter 2), Lachmann (1977, chapter 12), Lewin (1999), O’Driscolland Rizzo (1985, chapter 8) and Powell (2010). I borrow the jigsaw example from Horwitz (2011).18 An exception to the flow of labor to the tradable sector when elasticity of substitution is equal to one isthe case where foreign debts exceed capital stocks. In that case, the share of labor income over grossnational product is bigger than one and the first effect dominates the second ones.

The M-H business cycle theory, fiat currencies and open economies

intensively than the tradable sector. In fact, Young (2012) estimates values forelasticity of substitution for the United States at the industrial level and his findings“suggest that the tradables sector has a greater elasticity than the nontradables sector,though the difference is quite small.” (p. 32). Heterogeneous elasticity of substitutionbetween capital and labor does not only have implications for the results of fiscalpolicies, but also for the international effects of monetary policy that affects interestrates. The Cobb-Douglas unit elasticity of substitution falls short to describe thedynamics of the market process. Once a non-unitary elasticity of substitution is ac-knowledged, the reallocation pattern of factors of production becomes very complex.

Figures 4 and 5 show the effects on the center and on the periphery when the latterfollows a fixed and floating exchange rate policy respectively. For simplicity, thesefigures assume unit elasticities for the cases discussed above. The solid lines representthe situation before the expansionary monetary policy and the dashed lines show thesituation produced by an expansionary monetary policy. In addition to the axis thatrepresents the stages of production, a third axis shows the share of capital goodsassigned to nontradable and tradable industries. The light grey shows the share ofcapital goods assigned to nontradable industries, the dark grey area shows the share ofcapital goods assigned to tradable goods and the medium grey areas show thereallocation of capital goods between nontradable to tradable industries. The figuresassume that before the easy monetary policy the share of capital goods to tradable andnontradable industries is half and half. After the monetary policy, however, there is areallocation of capital goods to 1/3 and 2/3 that depends on the exchange rate policyfollowed by the periphery.

The figures show how easy monetary policy leads to a general lengthening of thecapital structure (the height of the jigsaw puzzle), but there is also a reallocation ofcapital goods between nontradable and tradable industries (the width of the jigsawpuzzle) depending on weather the periphery follows a fixed or floating exchange ratepolicy. Both of these effects represent a distortion in the capital structure.

3.3 International stages of production

To consider open economies can also imply that different countries are affecteddifferently since factors of production can be imported and stages of production

Fig. 4 Effects on the Capital Structure, Fix Exchange Rate.

N. Cachanosky

may be unevenly distributed between countries. The length of an unsustainable boomcan be increased and countries may go through the boom and bust differently.

Once resource scarcity becomes a constraint, the subsequent increase in the pricelevel signals to the central bank that the interest rate should be increased. In the caseof open economies, the supply of tradable factors of production depends on theinternational, rather than the domestic, supply. The production of nontradable goodscan be extended if the factors of production required are tradable and can beimported. As long as the required resources to increase the roundaboutness of thecapital structure can be imported, the resource constraint that signals the end of aboom can be postponed.

Since countries may specialize in different stages of production at the internationallevel, they will experience the boom and bust differently. Assume three countries,such that one of them is specialized in the production of capital goods required inlater stages of production, the second one on the capital goods required in middlestages of production, and the third one the capital goods required in the early stages ofproduction.

When the monetary policy lowers the interest rate, then the later and earlier stagesof production get affected to a larger extent than the middle stages of production. Theincrease in consumption drives an increase in the later stages of production, and thelower interest rate does the same for early stages of production. Resources from themiddle stages of production are reallocated to later and earlier stages of production.Therefore, countries that specialize in the production of tradable capital goodsrequired in early and late stages of production increase their output with respect tocountries that specialize in the production of tradable capital goods required in themiddle stages of the production process. The increase in demand of non-specificfactors of production in early and late stages of production bids up their prices,therefore to produce in the middle stages of production becomes more expensive.

4 Are business cycles more or less severe in the context of open economies?

Should we expect a Mises-Hayek business cycle to become more or less severe in thecontext of open economies with fiat currencies? Cowen (1997, pp. 60-61) argues that

Fig. 5 Effects on the Capital Structure, Floating Exchange Rate.

The M-H business cycle theory, fiat currencies and open economies

the “presence of a mobile pool of international capital may limit the importance ofmoney supply fluctuations in any single country.” According to Ritchie (2005),compared to a cycle in a closed economy, a given amount of monetary stimulus inan open economy should produce a boom-bust episode less severe since in aninternational context some of the monetary expansion are directed to investmentprojects abroad. For Ritchie, a business cycle in an open economy model shouldresult in a softer domestic economic cycle, but can also initiate a cyclical behavior inother countries.19

The fact that the center’s monetary expansion dilutes along a larger geographicalarea when considering the presence of a periphery points in the direction of a lesssevere business cycle. This is clear in the presence of a classic gold standard in thecontext of open economies when one central bank increases the issuance of banknotesand the other central banks redeem the banknotes for gold. However, with fiatcurrencies, the periphery can absorb increasing quantities of the center’s currencyas reserves and the center can import consumption goods and factors of production.

These factors imply that the boom can last longer in an international context. Also,as long as economic indicators do not move as fast as international clearing ofreserves, and the monetary authority does not react in advance, or misdiagnoses thebehavior of economic indicators, then the monetary policy may be in place for alonger time than would be the case under a classic gold standard.

In an international context, the severity of the business cycle impacts in twoopposite ways. Cowen (1997) and Ritchie (2005) are right that a given monetarydisturbance will produce a less severe cycle when it is considered over a largerterritory. However, this is no reason to assume this disturbance as given. In aninternational setting with fiat currencies domestic feedback forces are delayed andthus we should expect longer monetary distortions than would be possible in a closedeconomy or an open economy with classic gold standard, which effect dominates isan empirical question.

5 Conclusions

The Mises-Hayek business cycle theory can contribute to our understanding oftransmission of international business cycles, but to do so it needs to be updated sothat the theory considers fiat currencies rather than a gold standard monetary regime.The theory can support empirical findings related to international transmission ofbusiness cycles.

In the presence of an expansive monetary policy by the center, the periphery’scapital structure is not only distorted by an inefficient increase in its roundaboutness,but also through reallocation of heterogeneous capital goods between nontradable andtradable industries. The puzzle formed by the capital goods is affected on its two

19 Ritchie (2005, p. 158): “Comparado con un ciclo económico de una economía cerrada, una cantidaddada de estímulo monetario en una economía abierta debería producir un episodio de auge y depresiónmenos severo. En el modelo anterior, todo el dinero recientemente creado se dirigiría tanto al consumocomo a la inversión interna. En un contexto internacional alguno de estos dólares se dirigen a proyectos deinversión en otros países. […] Un modelo de economía abierta, por lo tanto, resulta en un ciclo económicointerno más suave, pero también puede disparar fluctuaciones macroeconómicas en otros países.”

N. Cachanosky

dimensions. An empirical question that arises from this paper is whether more capitalintensive and long term projects in small open economies with different exchange rateregimes are more sensitive to low interest rate policy by the center. If that is the case,then despite the fact that both economies follow a different exchange rate policy thebusiness cycle may look alike if such effect carries enough weight. Some scholarshave found empirical data that shows that countries with differing exchange ratesbehave more similarly than theory predicts (Canova 2005). Do, however, thesecountries follow similar distortions at the industrial level when looking at more andless capital intensive activities? In addition, do the relative price between nonotrad-able and tradable goods behave asymmetrically? Empirical studies should bear thisout and investigate the relevant magnitudes.

Acknowledgments I appreciate comments from Andreas Hoffmann, GP Manish, Ryan Murphy, MalavikaNair and Benjamin W. Powell, Andrew T. Young, and an anonymous referee. The usual caveats apply.

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