I'm amassing material on several issues in Austrian business cycle theory which do not seem to me well founded from a theoretical perspective. I hope noone has noticed these problems yet, so that when I solve them I will get in the Olympus together with Mises, but I often find papers which have treated some part of the problem and give important hints (not necessarily a satisfactory treatment) of the very same problems I was investigating.
One of these problems is how (in detail) money influences real activity. Objections that can be found in the literature are: small interest rate movements cannot explain much variation in investment decisions, the risk-free rate is dwarfed by risk premia, money is effective only in the short run and thus cannot affect long-term investment, rational entrepreneurs will make random (unbiased) errors and not biased errors favoring long-term with respect to short-term investment. Then, there are debates on whether the money stock (M) or the money flow (MV) set the stage for the boom-bust cycle, whether only M1 is relevant or also Mx, with x = 2, 3, ZM, whether price rigidities or injections effects are relevant, whether money is to be considered an information-carrying signal or (also) a means of exchange (in the former case, the Lucasian framework, monetary economics would be a mere subset of statistical estimation theory), whether rules are really preferable to discretion and which kind of rules (NGDP, M0, M1, M2 targets...) is preferable.
At the moment, I'm just collecting pieces. I've no full-fledged monetary theory in my head, and I only have a mass of papers on a shelf over my bed, which is somehow dangerous for my safety (and I hope this will incentivize me to read them as soon as possible).
Prof. Boettke has recently written a post on his blog regarding his public choice doubts about the policy of stabilizing the flow of monetary services (MV), also known as nominal GDP. I too have doubts, although nothing I can write anything of interest upon: I just started reading about monetary disequilibrium, and although I'm not convinced by this theory, I don't think I'm already grasping enough details. However, I will try to sketch an argument in favour of freezing the monetary base. I will divide the argument in steps.
1. A decentralized market system can work provided that the price system conveys correct information and gives correct incentives. The price system is endogenous to the market process, meaning that entrepreneurs improve upon the price system and the latter helps the former. Errors cannot be ruled out, but absent systematic distortions, it can be argued that entrepreneurs will act so as to push the economy as close as possible to some optimal equilibrium. For this point to be relevant, it is not necessary that the market system really reaches some optimal status, or even gets close to it, but only that monetary interventions cannot improve upon its behavior. It's a relative and not an absolute comparison.
2. Monetary policy has redistributive effects: it socializes part of the costs of investing and taking on risks. This implies that there are systematic externalities within the market process imposed upon by central bank policies. In these conditions, entrepreneurs are led astray and the price system is distorted. This is an induced market failure: it is not that the market process fails because there is something wrong with it (this could be contracted away, because any market failure is a profit opportunity, although its exploitation may be hampered by transaction costs), but the result of explitic policies imposed upon the market.
3. The key point here is that cost socialization devices shouldn't be used, otherwise entrepreneurs, instead of moving toward some sort of optimal equilibrium, move to a suboptimal one. Somehow, and in this somehow I should put something from a theoretical point of view, the market process and entepreneurship cannot be trusted upon to internalize monetary externalities (which are, despite their name, real externalities, not pecuniary ones). Here I give two examples of market distortion: the baseline (neoclassical) view of markets is that market agents optimize some utility function subject to constraints, and externalities hampers this process, which loses its optimality properties. A more realistic (austrian) view of markets is that markets are also made of contracts, institutions, bargaining, market/firm choices; externalities will lead all this complex entrepreneurial process astray, for instance by incentivizing insufficient screening in credit transactions. It money is the tailor which sews together the market process, whatever happens to money is something that is at least in part beyond the scope of entrepreneurship: coordination is bound to fail, and if monetary policies are systematic, failure will be systematic as well.
4. Any rule which eliminates or minimizes these redistributive effects will enable the market process to behave properly. If the rule is credible (although I think this hypothesis to be wholly unrealistic), which rule is followed matters much less than the fact that entrepreneurs no longer have any "externality producing" technology to exploit. This is a point that runs counter to both orthodox Austrian economics and monetary disequilibrium theory (although I only have a cursory understanding of the former).
5. In conventional Austrian economics, it is injection effects (increases in the money supply that are spent in credit markets) which start the business cycle. This process requires the cooperation of the banking system, which however will also pay the cost for these errors. Here's the point: if the monetary rule is followed, the banking system will be forced to internalize this cost, and will be less compelled to expand credit. The US banking system in the XIX century didn't need a central bank to cause a mess, but it can be argued that its weakness was due to limitations to branch banking, institutional uncertainty (silverites, greenbacks...), the forced use of securities as outside money (instead of plain gold, or, as I'm advocating, a fixed amount of base money), and moral hazard caused by banking holidays and specie conversion suspensions. Banking instability was not the rule in the world before central banks, so I guess there must be some specific US factor behind the misery of its monetary performance, both before and after the creation of the Fed.
6. In monetary disequilibrium theory, either in the aggregate Yeager's version or in the more Austrian Horwitz's version, it is monetary expansion in excess of money demand that starts the problem. This calls for some stabilization of MV, in which V is somehow taken as the inverse of money demand. The transmission mechanism relies on price rigidity: however, I believe that price rigidities, among all the frictions which create monetary non-neutrality, is unlikely to be the most important. Financial frictions, credit injection effects, moral hazard in the demand and supply of credit are likely to be much more relevant, although I can't justify this convinction in detail. The market being a complex system, it is unlikely that only one friction is relevant in causing monetary non-neutrality, and it must be noted that boom and bust policies are never a matter of mere money, but always involve credit, so that the secret of non-neutrality must lie in the relation between money and credit, and not in money per se (monetary disequilibrium, at least in the pre-Horwitz version, appears to be so aggregate that even the distinction between consumption and saving is irrelevant for its analysis of business downturns).
7. The "distorted market process" view is more robust because it does not rely on a single transmission mechanism. Whatever causes coordination problems by incentivizing excessive risk taking, capital consumption, overconsumption and malinvestment will more or less have the very same effect. Freezing the monetary base will eliminate the cost socialization technology that leads the market process astray. Thus, entrepreneurs will be forced to take into account the risk that their behavior will cause instability and, these costs being privatized, there will be an optimal risk-return choice. Externalities are likely to be the key building block in explaining monetary non-neutrality: tragedies of the commons that cannot be corrected by entrepreneurs, and impinge upon their ability to coordinate, may explain why injection effects are biased (without externalities, I have trouble imagining a tragedy of the commons in monetary matters). If Mises, answering in 1943 to Lachmann, said that the entrepreneurial cluster of error was not an apriori principle but an empirical generalization, systematic externalities created by monetary (and sometimes non-monetary) factors may give a robust microfoundation to this often criticized aspect of Austrian business cycle theory.
8. In the short run (at least a couple of years), this policy will be wildy contractionary because the banking system will be forced to step back, no longer being able to rely on the Fed's monetary safety net. Almost all of the risk-related aspects of the financial structure will be affected: there will be less maturity mismatch (monetary multipliers included), less financial leverage, less opacity and complexity, less reliance on originate-to-distribute business models, less currency carry trade, less short term foreign-currency borrowing... the enormous costs of this process are surely a very good reason to look for alternatives. But I see no alternatives that eliminate the root cause of the problem without having these adverse effects in the short run. Deleveraging is necessary to return to normalcy.
9. With respect to free banking, as described by Selgin and White, there is one major difference. Shifts in the currency/deposit mix will keep on having a destabilizing impact on the banking system: reserves turned circulating media will cause credit and monetary contraction, and banks will not be able to respond by printing banknotes convertible in outside money. Not being able to solve the problem by printing banknotes (offset by reduced deposits), banks will need to keep relatively high reserves in order to minimize the impact of these changes. With reserves in the range of 20%, it is likely that even large shifts in the demand of banknotes against deposits will have a minor impact. This war chest may not be required in free banking (with freedom of note issuance), but I don't see how it can be avoided in the system I'm advocating, which is surely easier to implement than an overall banking reform. I have no particular reasons not to eliminate this source of disturbance by also introducing freedom of note issuance.
10. My policy will not be able to eliminate all injection effects (banks may continue to issue money primarily through loans), price-stickiness effects (banks are constrained in their capacity of accomodating changes in the demand for money, because they need high reserve ratios to accomodate the risk of deposit/note shifts), and financial friction effects (there will always be moral hazard and adverse selection issues to take care of throughout the financial sector). The point is that there would no longer be an externality producing technology to shift eventual costs to third parties: so the entrepreneurial process itself is not hampered, and may be able to take into account and optimally adjust to all these factors.
11. The only remaining limitation, thus, is what limits entrepreneurship: transaction costs in credit markets and in monetary transactions (I think the former to be more relevant). Absent the cost socialization technology created by the central bank, all benefits and costs are private, or at least can be made private by entrepreneurial experimentation with the market structure. Only problems that are impossible to solve because they are too complex, because of too high transaction costs, or because they require too much information, will remain. But without systematic moral hazard agents have at least the incentive to avoid problems they cannot solve.
12 Finally, the monetary base is easy to check, and, thus, public choice concerns, to the extent that the rule is respected, are relatively low: there is nothing to estimate, like the neutral rate of interest and nothing to distinguish, like good (productivity driven) and bad (money side) deflation. Of course, there will be no political will to adopt this policy, which given the amount of confusion I have on these issues, may not be a bad thing.