Price Stability and Entrepreneurship

Monetary economists tend to fall into one or both of two categories: they are proponents of either price stability or inflation. Some, like University of Chicago’s Luigi Zingales, proposes a government entity to guard us from inflation. Others, like Princeton’s Paul Krugman, seems to see only problems with price stability – but sees only good things come out of inflation.

Interestingly, there is little talk about entrepreneurship when monetary theorists talk. An exception is the 20th century economist Ludwig von Mises, an economics system builder who developed a subjective theory of money as well as connected it to the market’s structure of production, entrepreneurship, and linked them all in a theory of business cycles.

Whether or not we adopt Mises’s views, it is fascinating to adopt an entrepreneurial perspective when discussing monetary theory and policy. What is the role of entrepreneurship and how does entrepreneurship fare under or affect market prices?

Well, let’s imagine an entrepreneur is either alert to arbitrage opportunities (as in Kirzner, 1973), is an innovator that creates new combinations of resources (as in Schumpeter, 1911), or exercises superior judgment in bearing uncertainty in productive enterprises for profit (as in Knight, 1921). Then imagine that this entrepreneur acts under any conceivable monetary regime. What is the effect of entrepreneurship on market prices?

The Kirznerian arbitrageur acts as an equalizer of prices and therefore creates the market price through buying where prices are low and selling where prices are high. The only reason a Kirznerian entrepreneur can make a profit is because market prices have not yet been established, which means the market is in a disequilibrium seeking equilibration through entrepreneurship. Was there no entrepreneurship but the Kirznerian entrepreneur, then we would see no changes to the market except for this equilibration.

In other words, one way to see it is that Kirznerian entrepreneurship brings about price stability (assuming there are no changes in the market). But this is only true if we adopt an aggregated view where we look at the whole market and the market end-price when all arbitrage opportunities have been exhausted. This is not how consumers see it–Kirzner’s arbitraging entrepreneur changes prices in both the market where he buys (prices increase) and the market where he sells (prices decrease).

The Schumpeterian and Knightian entrepreneurs cause more “severe” changes. Schumpeter’s entrepreneur is an innovator that forcefully pushes the market out of equilibrium through introducing new production processes or new products. This entrepreneur does not necessarily undo Kirzner’s entrepreneur’s arbitrage efforts, but creates new such opportunities. And Knight’s entrepreneur uses the firm to generate profits through production. In both cases, we expect prices relative to the satisfaction of consumer wants to fall. If they do not, then we see only failed entrepreneurship through losses–and these ventures are bound to stop in a not too distant future when they run out of money.

Altogether, therefore, entrepreneurship changes prices. This makes price stability a strange aim–prices can only be “stable” if we assume nothing changes, which is to say that the market lacks entrepreneurship.

An inflationary regime would mean prices tend to always go up. They go up because there is more money around and, consequently, the value of money is going down–so you have to spend more of it to buy products. Inflation doesn’t hit the market uniformly, which is something the French banker and economist Richard Cantillon discovered in the mid-18th century. This means prices change all over the place, but they change at different times and they all change until all prices have settled to reflect the new value of money.

Obviously, this creates new opportunities for the Kirznerian arbitrageur who may be able to buy at old money prices and sell at new ones–and thereby make a profit. Inflation would also undo much (or all) of the fall in prices that entrepreneurship brings about. But to what degree? We cannot tell. Due to the “cantillon effects” (the fact that inflation hits different sectors at different times as new money trickles through the economy), prices are all messed up–they fall in places where we have entrepreneurship but the new money has not yet “arrived”; they would tend to rise in places where inflation hits first; and there is no telling what would happen in sectors where there is entrepreneurship and inflation–maybe they stay the same, maybe they fall or rise.

In this mess, economists attempt to measure the inflationary effect on market prices of the monetary policy. Such “price inflation” (or deflation) is assumed to have different effects depending on sign and magnitude. And the real effect on prices depends ultimately on entrepreneurship in the specific sectors of the economy. But entrepreneurship is left out of the equation, simply because it is too difficult to measure.

What is interesting here is the discussion on price stability versus inflation. If we measure inflation in terms of market prices, then we have inflation only when and where prices go up. This is only the case if the money supply is increased to such a degree that it neutralizes the natural money fall effected by entrepreneurship–and more. The market, in other words, is flooded by newly printed money. We need to ask what is the effect on entrepreneurship by such policies. The answer is not obvious.

And we have price stability only where and when the increased money supply affects market prices exactly in the same way, at the same time, and in the same places as prices were destined to fall due to entrepreneurship. Maintaining price stability appears to be an impossible endeavor, unless we assume we know everything about entrepreneurship and its effect on prices. But we know very little about this.

The question is then: what monetary policy is most beneficial for society at large? The impossible price stability regime or the flooding of the economy with vast amounts of new money? To answer this question, we need to figure out the effect of increases to the money supply on entrepreneurship. This is something I do, at least in part, in a working paper co-authored with Matt McCaffrey on the effects of regime uncertainty on entrepreneurship.

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