Booms, Bubbles, Busts, and Bogus Dichotomies

by George Selgin August 30th, 2013 6:55 pm

Having learned my monetary economics from both the great monetarist economists and their Austrian counterparts, I've always chafed at the tendency of people, including members of both schools, to treat their alternative explanations of recessions and depressions as being mutually exclusive or incompatible. According to this tendency, a downturn must be caused either by a deficient money supply, and consequent collapse of spending, or by previous, excessive monetary expansion, and consequent, unsustainable changes to an economy's structure of production.

During the 1930s and ever since, this dichotomy has split economists into two battling camps: those who have blamed the Fed only for having allowed spending to shrink after 1929, while insisting that it was doing a bang-up job until then, and those who have blamed the Fed for fueling an unsustainable boom during the latter 1920s, while treating the collapse of the thirties as a needed purging of prior "malinvestment." As everyone except Paul Krugman knows, the Austrian view, or something like it, had many adherents when the depression began. But since then, and partly owing (paradoxically enough) to the influence of Keynes's General Theory, with its treatment of deficient aggregate demand as the problem of modern capitalist economies, the monetarist position has become much more popular, at least among economists.

It is, of course, true that monetary policy cannot be both excessively easy and excessively tight at any one time. But one needn't imagine otherwise to see merit in both the Austrian and the monetarist stories. One might, first of all, believe that some historical cycles fit the Austrian view, while others fit the monetarist one. But one can also believe that both theories help to account for any one cycle, with excessively easy money causing an unsustainable boom, and excessively tight money adding to the severity of the consequent downturn. I put the matter to my undergraduates, who seem to have little trouble "getting" it, like this: A fellow has an unfortunate habit of occasionally going out on a late-night drinking binge, from which he staggers home, stupefied and nauseated. One night his wife, sick and tired of his boozing, beans him with a heavy frying pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by the ruckus, pokes his head into the doorway, sees our drunkard lying unconscious, in a pool of puke, with a huge lump on his skull. "What the heck happened to him?," he asks. Must the correct answer be either "He's had too much to drink" or "I bashed his head"? Can't it be "He drank too much and then I bashed his head"? If it can, then why can't the correct answer to the question, "What laid the U.S. economy so low in the early 1930s?" be that it no sooner started to pay the inevitable price for having gone on an easy money binge when it got walloped by a great monetary contraction?

In insisting that one shouldn't have to blame a bust either on excessive or on deficient money, I do not mean to expose myself to the charge of making the opposite error. My position isn't that excessive and tight money must both play a part in every bust. Nor is it that, when both have played a part, each part must have been equally important. The question of the relative historical importance of the two explanations is an empirical one, concerning which intelligent and open-minded researchers may disagree. The point I seek to defend is that those who argue as if only one of the two theories can possibly have merit cannot do so on logical grounds. Instead, they must implicitly assume either that central banks tend to err in one direction only, or that, if they err in both, only their errors in one direction have important cyclical consequences.

The history of persistent if not severe inflation on one hand and of infrequent but severe deflations on the other surely allows us to reject the first possibility. What grounds are there, then, for believing that money is roughly "neutral" when its nominal quantity grows more rapidly than the real demand for it, but not when its quantity grows less rapidly than that demand, as some monetarists maintain, or for believing precisely the opposite, as some Austrian's do? New Classical economists, whatever their other faults, are at least consistent in assuming that money prices are perfectly flexible both upwards and downwards, leaving no scope for any sort of monetary innovations to affect real economic activity except to the extent that people observe price changes imperfectly and therefore confuse general changes with relative ones. Both old-fashioned and "market" monetarists, on the other hand, argue as if the economy has to "grope" its way slowly and painfully toward a lowered set of equilibrium prices only, while adjusting to a raised set of equilibrium prices as swiftly and painlessly as it might were a Walrasian auctioneer in charge. Many Austrians, on the other hand, insist that monetary expansion necessarily distorts relative prices, and interest rates especially, in the short-run, while also arguing as if actual prices have no trouble keeping pace with their theoretical market-clearing values even as those values collapse.

Of these two equally one-sided treatments of monetary non-neutrality, the monetarist alternative seems to me somewhat more understandable. For monetarists, like New Keynesians, attribute the non-neutral effects of monetary change to nominal price rigidities. They can thus argue, in defense of their one sided view, that it follows logically from the fact that certain prices, and wage rates especially, are less rigid upward than downward. That's the thinking behind Milton Friedman's "plucking" model, according to which potential GNP is a relatively taught string, and actual GNP is the same string yanked downward here and there by money shortages, and his corresponding denial of the existence of business "cycles." But "less rigid" isn't the same as "perfectly flexible" or "continuously market clearing." So although Friedman's perspective might justify his holding that a given percentage reduction in the money stock will have greater real consequences than a similar increase, other things equal, it alone doesn't suffice to sustain the view that excessively easy monetary policy is entirely incapable of causing booms. What's more, as Roger Garrison has pointed out, the fact that real output appears to fit the "plucking" story doesn't itself rule out the presence of unsustainable booms, which (if the Austrian theory of them is correct) involve not so much an expansion of total output as a change in its composition.

Austrians, in contrast, tend to attribute money's non-neutrality, not to general price rigidities, but to so-called "injection" effects. In a modern monetary system such effects result from the tendency of changes in the nominal quantity of money to be linked to like changes in nominal lending, and particularly to changes in the nominal quantity of funds being channeled by central banks into markets for government securities and bank reserves. The influence of monetary innovations will therefore be disproportionately felt in particular loan markets before radiating from them to the rest of the economy. It is not easy to see why monetary "siphoning" effects, to coin a term for them, should not be just as non-neutral and important as injection effects of like magnitude. To the extent that the monetary transmission mechanism relies upon a credit channel, that channel flows both ways.

A division of economists resembling that concerning the role of monetary policy in the Great Depression has developed as well in the wake of the recent boom-bust cycle. Only this time, oddly enough, several prominent monetarists and fellow travelers (among them, Anna Schwartz, Allan Meltzer, and John Taylor) have actually joined ranks with Austrians in holding excessively easy monetary policy in the wake of the dot-com crash to have been at least partly responsible for both the housing boom and the consequent bust. With so many old-school monetarists switching sides, the challenge of denying that monetary policy ever causes unsustainable booms, and of claiming, with regard to the most recent cycle, that the Fed was doing a fine job until until house prices started falling, has instead been taken up by Scott Sumner and some of his fellow Market Monetarists.

Sumner, like Milton Friedman, forthrightly denies that there's such a thing as booms, or at least of booms caused by easy money, to the point of taking exception to a recent statement by President Obama to the effect that, among its other responsibilities, the Fed should guard against "bubbles." But here, and unlike Friedman, Sumner basis his position, not merely on the claim that prices are more flexible upwards than downwards, but on a dichotomy erected in the literature on asset price movements, according to which upward movements are either sustainable consequences of improvements in economic "fundamentals," or are "bubbles" in the strict sense of the term, inflated by what Alan Greenspan called speculators' "irrational exuberance," and therefore capable of bursting at any time. Since monetary policy isn't the source of either improvements in economic fundamentals or outbreaks of irrational exuberance, the fundamentals-vs-bubbles dichotomy implies that monetary policy is never to blame for changes in real asset prices, whether those changes are sustainable or not. If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary policymakers shouldn't be concerned about booms" crowd are right, and the Austrians, Schwartz, Taylor, and others, including Obama and his advisors, who would hold the Fed responsible for avoiding booms, are full of baloney.

But it isn't the Austrian view, but the bubbles-vs-fundamentals dichotomy itself, that's full of baloney. That dichotomy simply overlooks the possibility that speculators might respond rationally to interest rate reductions that look like changes to "fundamental" asset-price determinants, that is, to relatively "deep" economic parameters, but are actually monetary policy-inspired downward deviations of actual rates from their genuinely fundamental ("natural") levels. Because actual rates must inevitably return to their natural levels, real asset price movements inspired by "unnatural" interest rate movements, though perfectly rationale, are also unsustainable. Yet to rule such asset price movements out one would have to claim either that monetary policy isn't capable of influencing real interest rates, even in the short-run, or that the temporary interest-rate effects of monetary policy can have no bearing upon the discount factors that implicitly inform the valuation of amy durable asset. Here again, the burden seems too great for mere a priori reasoning to bear, and we are left waiting to set our eyes upon such empirical studies as are capable of bearing it.

In the meantime, it seems to me that there is a good reasons for not buying into Friedman's view that there is no such thing as a business cycle, or Sumner's equivalent claim that there is no such thing as a monetary-policy-induced boom. The reason is that there is too much anecdotal evidence suggesting that doing so would be imprudent. The terms "business cycle" and "boom," together with "bubble" and "mania," came into widespread use because they were, and still are, convenient if inaccurate names for actual economic phenomena. The expression "business cycle," in particular, owes its popularity to the impression many persons have formed that booms and busts are frequently connected to one another, with the former proceeding the latter; and it was that impression that inspired Mises and Hayek do develop their "cycle" or boom-bust theory rather than a mere theory of busts, and that has inspired Minsky, Kindleberger, and many others to describe and to theorize about recurring episodes of "Mania, Panic, and Crash." Nor is the connection intuitively hard to grasp: the most severe downturns do indeed, as monetarists rightly emphasis, involve severe monetary shortages. But such severe shortages are themselves connected to financial crashes, which connect, or at least appear to connect, to prior booms, if not to "manias." That the nature of the connections in question, and the role monetary policy plays in them, remains poorly understood is undoubtedly true. But our ignorance of these details hardly justifies proceeding as if booms never happened, or as if monetary policymakers should never take steps to avoid fueling them. On the contrary: the non-trivial possibility that an ounce of boom prevention is worth a pound of quantitative easing makes worrying about booms very prudent indeed, and prudent even for those who believe that monetary shortages are by far the most important proximate cause of recessions and depressions.

Does my saying that Scott and others err in suggesting that monetary policymakers ought not to worry about stoking booms mean that I also disagree with Scott's arguments favoring the targeting NGDP? Not at all. I'm merely insisting that a sound monetary policy or monetary system is one that avoids upward departures of NGDP from target just as surely as it does downward ones. Nor do I imagine that Scott himself would disagree, since his preferred NGDP targeting mechanism would automatically achieve this very result. But I worry that other NGDP targeting proponents have allowed themselves to become so wrapped up in recent experience, and so inclined thereby to counter arguments for monetary restraint, that they have allowed themselves either to forget that a time will come, if it hasn't come yet, when such restraint will be just the thing needed to keep NGDP on target, or to treat Scott's boom-denialism as grounds for holding that, while there can be too little NGDP, there can't really be too much. (Or, what is almost as bad, that there can't be too much so long as the inflation rate isn't increasing, which amounts to tacitly abandoning NGDP targeting in favor of inflation targeting whenever the the latter policy is the looser of the two.) I urge such "monetarists" to recall the damage Keynes did by taking such a short-term view, while disparaging those who worried about the long run. "Keynesiansim" thus became what Keynes himself never intended it to be, which is to say, a set of arguments for putting up with inflation. Let's not let Market Monetarism become perverted into set of arguments for putting up with unsustainable booms.

Addendum: Scott has responded, claiming that I am wrong in portraying him as a money-induced unsustainable boom denialist. I appreciate his attempts to reassure me, and yet can't help thinking that he has nevertheless supplied some reasons for my having characterized his thinking as I did. For example, when Scott writes that "asset prices should reflect fundamentals. Interest rates are one of the fundamental factors that ought to be reflected in asset prices. When rates are low, holding the expected future stream of profits constant, asset prices should be high. Bubbles are usually defined as a period when asset prices exceed their fundamental value. If asset prices accurately reflect the fact that rates are low, then that’s obviously not a bubble," he certainly seems to accept the bubbles-vs.fundamentals dichotomy about which I complain above, with its implicit exclusion of the possibility of a boom based on lending rates that have been driven by "unnaturally" low by means of excessively easy money. Scott only reinforces this interpretation by further observing, in the same post, that "[i]t’s not clear what people mean when they talk of “artificially” low interest rates. The government doesn’t put a legal cap on rates in the private markets, in the way that the city of New York caps rents." Now if that isn't sweeping aside the whole Wicksellian apparatus, with its distinction between "natural" and "actual" interest rates, then I don't know what is.

Also, while Scott protests that he does not deny a possible role for easy money in fueling booms, it's far from evident that he considers this something other than a merely theoretical possibility. He denies (appealing again to the bubbles-vs.-fundamentals dichotomy), that monetary policy played any part in the Roaring Twenties (while asserting that NGDP per capita fell during that decade, though that isn't my understanding*); and he denies that it played any part in the recent housing boom. With respect to the latter boom he observes, in response to a commentator, that "a housing boom is just as likely to occur with 3% trend NGDP growth as 5% NGDP growth. Money is approximately superneutral. I completely reject the notion that Fed policy is mostly to blame for the housing bubble–it was bad public (regulatory) policies plus stupid decisions by private actors. I’m not saying Fed policy had no effect, but it was a minor factor." Scott's claim here, though not altogether wrong as a claim about comparitive steady states, might nonetheless be taken to suggest that there's little reason to be concerned about adverse effects, apart from inflation, of faster than usual NGDP growth. And this view in turn encourages people to think that, when NGDP grows more rapidly than usual, there's no harm in sitting back and enjoying it so long as it doesn't raise the inflation rate much. That is, it encourages them to favor replenishing the punchbowl whenever the party get's dull, but not removing it when the party starts getting wild.**

Regarded as empirical claims only, Scott's assertions may of course be valid. But I think the evidence from these and other quotes from him suggests that, while he clearly believes that easy money can influence interest rates, he does not believe, as a matter of theory, and based largely on his acceptance of the bubble-fundamentals dichotomy along with the EMS, as well as his related inclination to brush-aside Wicksell's arguments as to the possibility as well as the unsustainability of "unnatural" changes in interest rates, that by doing so it can contribute to an unsustainable asset boom.

*Here, for what it's worth, is the plot I get when I divide nominal NGDP (millions) by population (thousands) using stats from FRED's macrohistory data base:


**Previously I put the matter here in stronger terms that I now see were unjustified. Sorry, Scott! (Added 10/3/2013 at 9:36PM).


The necessity of distinctions

by Kurt Schuler August 29th, 2013 10:46 pm

Paul Marks, a frequent poster of comments, claims that the concept of a gold standard is misleading because “either gold is the money or it is not.” Sorry, the epigones of Murray Rothbard need to learn a lot more monetary history here. There are many kinds of arrangements under which “gold is the money” but who can get the money and under what circumstances is restricted. Consider these cases:

Medieval gold standard: Before the era of circulating notes. People often used “imaginary monies” corresponding to no current coin in circulation. If you got paid in gold, it would be with a grab-bag of available coins, perhaps by weight or perhaps by tale (face denomination) if the coins were not terribly worn and had a good reputation for uniformity.

Classical gold standard (1800s-1914): Half the world or more did not have central banks. Gold was minted into coins that circulated widely. People could redeem even small amounts for standard gold coins. Redemption even for large amounts was often made with gold coins and not with bullion.

Gold bullion standard: First proposed, I believe, by David Ricardo at a time when Britain was off the gold standard and gold coins had disappeared from circulation. The minimum unit of redemption would be a gold bar with a high value, restricting redemption in practice mainly to banks.

Currency board on gold: Yes, there were a few cases where currency boards held substantial reserves (one-third or more of the value of currency in circulation) in precious metals, and the rest in foreign securities.

Gold exchange standard: As practiced in the 1920s, countries on the gold exchange standard held large amounts of interest-bearing foreign assets denominated in major gold-convertible currencies where before World War I they would instead have held gold. The result looked a lot like the classical gold standard on the surface but had an element of foreign-currency risk for gold-exchange central banks that had been smaller under the classical gold standard.

Bretton Woods system: Central banking had taken over the world by this time. No gold coins circulated. Only one currency in the system, the U.S. dollar, was readily redeemable for gold, and then only by foreign governments, not by U.S. or foreign private individuals or banks. Exchange controls on most currencies in addition to restrictions on the use of gold.

Advanced free banking system on a gold standard: Gold coins are legal but nobody wants them for everyday use because they are cumbersome, and maybe nobody even mints them. The public is free to demand gold from banks but nobody does so for monetary purposes. Instead, gold remains in bank vaults and serves only as a medium of settlement among banks, except when demand to use gold in industry makes some withdrawal of gold from banks profitable.

100% gold standard: As George Selgin has pointed out, this is a system that seems never to have existed anywhere that banking has been competitive.

If you don’t distinguish among the characteristics of these arrangements, and that accordingly all but the first and maybe the last are systems in which “gold is not the money,” you can’t understand thoroughly how they work. Additionally, by implicitly lumping them with fiat money systems, in which gold is definitely not the money, you lose insight into why the various gold standards, whatever their flaws, have had lower inflation than fiat money systems.


Huff Post Live Today

by Steve Horwitz August 29th, 2013 10:54 am

I'm scheduled to be on this segment of Huff Post Live at around 2:40EDT. Hope you can tune in.


Bitcoin news

by Kurt Schuler August 27th, 2013 8:10 am

Recently issued Mercatus Center study by Jerry Brito and Andrea Castillo here. Washington Post story on Bitcoin meeting with regulators here; a story on page A12 of today's print edition, by the same reporter, has follow-up information that does not seem to be online yet.


A free banking approach to the $1 bill

by Kurt Schuler August 25th, 2013 3:16 pm

In the Wall Street Journal, Steve Hanke discusses the idea of eliminating the $1 bill, which has been proposed on the grounds that $1 coins are cheaper and would save the federal government money. He proposes instead that private issuers be allowed to issue $1 bills. People can then decide whether they prefer government $1 coins to private $1 bills. As I showed in a Cato Journal article some years ago, a provision in a reform of U.S. banking law in 1994 made it is legal for U.S. banks to issue notes. It is unclear whether the drafters of the law were aware that they were (re)legalizing private note issue. So far no banks have issued notes. At the Cato Institute's annual monetary conference a couple of years ago when the subject was discussed, my impression was that would-be private issuers of notes want additional assurance. The law lets them issue notes but they are concerned about the possibility of regulatory or other forms of harassment for doing so.

George Selgin has advocated privatizing the production of pennies, which the federal government has also talked about eliminating. Incidentally, from a quick review of the U.S. Code I did not see any explicit provision that minting coins is a government monopoly, though maybe I missed it and a reader can enlighten me. The monopoly has been enforced through the counterfeiting laws, including in the Liberty Dollar case.


The intuition is the real economics

by Kurt Schuler August 24th, 2013 11:24 pm

Noah Smith is encountering the frustration that most graduate students in economics experience when their professors put them through a math wringer that the students correctly suspect is largely useless. (In the more than 20 years I have worked on economic policy, as a consultant in several countries, in the U.S. Congress, and at the U.S. Treasury, I do not recall having used anything beyond basic algebra and some elementary statistics that you can run in Excel, such as a regression line in a scatterplot diagram. Only a few people I know who work on economic policy use more math than that.) Bryan Caplan at EconLog maintains that "economath fails the cost-benefit test."

I made a few comments on models in a post months ago. Now I add that what graduate school professors call, often disparagingly, "intuition" is in fact the real economics. When mathematicians say they are giving an intuitive explanation, they mean they are skipping important steps for the sake of making the presentation more understandable, or in some cases, they mean they suspect they know the answer but are missing some steps to prove it. When economists say they are giving an intuitive explanation, they mean they are explaining how people think and act. But people's thoughts and actions are the building blocks of economics!  Any satisfactory account of economic phenomena has to be able to show how they arise from those building blocks. The building blocks are also what we use to navigate our way through the human world. The main reason that graduate school economath is so useless later in most careers is that it leaves out the thinking, acting people who make the economy hum. Instead of stories about people, it offers much less satisfying stories having to do with aggregates, propensities, and the like.

"Intuition" is not the right word for the explanations in terms of thoughts and actions that good economics offers. A more precise term is fortunately at hand: Verstehen, the German for "understanding." As many Austrian economists and German-language or German-influenced writers in other social sciences have used it, it means our understanding of other people's intentions and actions. More English-speaking need to become familiar with it.


Bretton Woods, compared to what?

by Kurt Schuler August 20th, 2013 11:43 pm

The Bretton Woods Transcripts, which I edited with Andrew Rosenberg, is now available as a 700-page hardback--at, I might add, an unusually low price for such a book. Also available, for free, is a document called Questions and Answers on the Bank for Reconstruction and Development distributed at the Bretton Woods conference to explain the proposed organization now best known as the World Bank.

A post by Pete Boettke on Henry Hazlitt and Pete's accompanying working paper (which you can go to from the post) reminded me that Hazlitt was a great critic of Bretton Woods and was eventually proved right about the Bretton Woods system of pegged exchange rates. Though I respect Hazlitt, in editing the book and the "Questions and Answers" document I have come to a greater appreciation for the founders of the Bretton Woods system. The late Don Lavoie, one of my professors at George Mason University, always stressed that in economics a key question was "Compared to what?" What is the proper standard for evaluation? He particularly emphasized it in connection with comparisons between economic systems. (This was in the 1980s, before the collapse of the Soviet bloc.) Comparing real capitalism to hypothetical socialism, for instance, was faulty because it compared an imperfect but workable system with a perfect but unworkable, in the sense of never existing, system.

Looking back at the Bretton Woods conference, there are a number of possibilities to compare its consequences to. One is the pre-World War I arrangements of the gold standard, free movement of capital and people, and small government. Another is the currency controls and trade restrictions of the 1930s that arose out of the Great Depression. Still another is the war economies that existed at the time of Bretton Woods, with their extensive price controls, quotas, and other features of centralized economic planning. Compared to the pre-World War I system, Bretton Woods looks less free and less robust. (Remember that it took a world war to end the pre-World War I system, whereas no such great shock was present when the United States brought down the Bretton Woods gold standard in 1971.) Compared to the 1930s, Bretton Woods looks superior as a way of promoting harmony among national economic policies and creating space for freer trade. Compared to wartime centralized economic planning, it looks far superior, though of course it was explicitly designed as a peacetime system, not applicable in wartime.

Hazlitt was comparing Bretton Woods to the pre-World War I status quo. The delegates at Bretton Woods, on the other hand, were comparing it to the terrible experience of the previous 15 years. Hazlitt notwithstanding, a return to the pre-World War I status quo was not politically feasible in 1944, not in the United States and especially not elsewhere. I consider that under the circumstances the relevant comparison was the experience of the previous 15 years. Despite its flaws, Bretton Woods laid foundations for the increasingly liberalized trade that has marked the nearly 70 years since. It is also worth mentioning that for a few months there appeared to be the tantalizing possibility that the Bretton Woods agreements would be fully global, including the Soviet Union, all the countries occupied by Germany and, after a period of postwar rehabilitation, the Axis powers. That was worth sacrificing a little purity; it would have been as close as humanity has ever come to making real Immanuel Kant's dream of suitable arrangements to foster Perpetual Peace. The Soviet Union signed the Bretton Woods agreements but then failed to ratify them, and its satellites never joined or withdrew from the International Monetary Fund and the World Bank. Not until after the collapse of the Soviet Union would most of their successor states join. The IMF and World Bank then became fully global institutions, reflecting that the failure of socialism in the Soviet bloc had created more of an international consensus about economic policy than had existed at any time since before World War I.


What Bank Intermediation Means

by George Selgin August 18th, 2013 1:28 pm

As part of my relentless (some will say obsessive) quest to stamp-out fallacies perpetrated by the 100-percent reserve bunch, I found myself engaged in a discussion with some of them in the comments section of my last post. As the discussion took place some days after that post was published, I hope I may be pardoned for reproducing parts of it, in the hope that doing so might further my overarching objective.

The discussion was prompted by a remark from 100-percenter Paul Marks, who insisted (with his usual emphasis) that "Total borrowing (of all types) must never be greater than total REAL savings of PYSICAL [sic] money. ...I repeat that I am NOT making a legal point - I am making a moral and logical one." In reply I wrote as follows:

Paul, what you are saying makes no sense at all. It is the very nature of lending and borrowing of "physical" assets through intermediaries that the value of financial assets or IOUs tends to exceed that of the physical assets involved. I lend a cow to A, an intermediary, in return for A's promise to return the cow to me with interest; A lends the same cow to B, in return for a like promise from B. So: one cow, two promises, no harm, no foul.

I then added,

Just to be clear, Paul, in case the "morality" of intermediated lending should not be sufficiently evident: In the example above, I understand that A is acting as my agent; because I am not in a position to expend resources to discover a worthy borrower to whom I may lend my cow, with reasonable assurance of having it returned with interest, or because I am otherwise unable or unwilling to execute the necessary contracts myself, I allow A to take on these tasks for me, in return for his own commitment to repay my principle with interest.

Where loans of "physical" money are involved, the fungibility of that money allows a bank--which is just a name for an intermediary of money loans--to assemble loans from numerous creditors, and to lend funds so assembled to an equally diverse set of borrowers, all of which serves to reduce, ceteris paribus, the banker's prospects of being unable to meet his various commitments, lowering in turn the credit risk borne by individual bank creditors.

For centuries persons with idle base money balances have found it convenient to relinquish them to bankers as a means for earning interest on such balances with less risk than they would incur by lending them directly, while also (in cases in which deposits are made in exchange for a bank's demandable debt instruments) having access to means of payment often far more convenient than physical (narrow) money itself.

Of course, as with all forms of lending, lending through banks is not risk free. But that hardly makes such lending either unethical or imprudent. Those who, rather than wishing merely to oppose such regulatory interventions as serve to augment artificially the prospects of bank failures and financial crises, plead instead for banning bank-intermediated lending altogether, though they affect to argue as proponents of freedom and morality, in fact seek to arbitrarily limit the scope of freedom of contract, and by doing so make themselves far more deserving of the charge of immorality than the bankers whom they so loftily--and so uncomprehendingly--criticize.

Reacting to my first remark, perhaps without having read the second, Mike Sproul wrote:

Except that if B doesn't pay A, and A doesn't pay you, there is both harm and foul. If the only security for A's IOU is A's possession of B's IOU, then you would insist that B's IOU be signed over to you when A lent the cow to B. Either that, or you would have placed 1 cow's worth of lien on A's other property before accepting A's IOU in the first place. Try it with a house sometime, and see if you can get lenders to carry $200,000 worth of IOU's based only upon a $100,000 house.

To which I observed:

Like I said, all lending is risky. And of course (in the absence of government bailouts) intermediaries don't survive if they continue to make excessively risky or insufficiently secured loans. The tendency, when it comes to banking, for some to hold the industry to be either inherently untenable or immoral or both because banks will occasionally fail is frankly silly. Applied to industry in general, this tendency would have it that we should put an end to all business activity, on the grounds that some people are bound to lose their shirts otherwise!

No one, in any event, is "forced" to transact with a fractional reserve bank. No law, so far as I am aware, has ever prohibited the establishment of 100-percent warehouse alternatives. (Please don't bring up deposit insurance: what I am saying goes for the long history predating both that and TBTF.) No law prevents anyone from keeping cash in a safe or safety deposit box. To the extent that the law has ever had any say regarding bank's [sic] reserve-holding decisions, that say has ever been one commanding banks to maintain some minimum positive reserve ratio--never a "maximum" ratio! And of the few important 100-percent "banks" ever established, almost all have been government sponsored arrangements, usually subsidized or otherwise propped up by laws banning would-be fractional reserve rivals.

I do sympathize with those younger students of economics, and of Austrian economics especially, who, having fallen under the sway of anti-fractional reserve propaganda disseminated by Rothbardians and their fellow travelers, have been tempted to jump on the anti-FRB bandwagon. But for the grown-ups responsible for so tempting them, I confess I have nothing but contempt. The a-priori grounds upon which they condemn FRB are utterly without merit, while a superabundance of empirical evidence flatly contradicts their positions. They are to Austrian economics what the Flat Earth Society is to geology, which is to say (to employ Leland Yeager's expression): an embarrassing excrescence.

I urge readers of freebanking.org who agree with me, and who know some of the misinformed students to whom I refer, to share this exchange with them, in the hope that it may contribute toward their eventual, successful deprogramming. We can, of course, never hope to purge Austrian economics entirely of the 100-percent-reserve bacilli by which it has become infected in recent years. But we can at least hope to build up such a core of well-informed antibodies as may eventually prevent those bacilli from doing any more harm to the main body of Austrian thought than the occasional e-coli does to an otherwise robust digestive tract.


Krugman on Friedman, Hayek, and Liquidationism

by Larry White August 12th, 2013 4:31 pm

In a blog post yesterday, entitled “Friedman and the Austrians” , Paul Krugman quotes Milton Friedman’s charge that in the “London School (really Austrian) view,” i.e. the view held by F. A. Hayek and Lionel Robbins,

the depression was an inevitable result of the prior boom, that it was deepened by the attempts to prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by “easy money” policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms.

Krugman then remarks:

I have, incidentally, seen attempts to claim that nobody believed this, or at any rate that Hayek never believed this, and that characterizing Hayek as a liquidationist is some kind of liberal libel. This is really a case of who are you gonna believe, me or your lying eyes.

One of the "attemps" Krugman may be referring to is my June 2008 article in the Journal of Money, Credit, and Banking, “Did Hayek and Robbins Deepen the Great Depression?” (Ungated pre-publication version here). Or he may be referring to subsequent discussion of the question on Brad DeLong’s blog -- if you follow this link, please scroll down to see my comments on DeLong’s post.

In either case Krugman’s remarks call for a reply.

In the 2008 article I point out that Hayek enunciated a monetary policy norm of stabilizing nominal income (aka nominal aggregate demand, or MV in the equation of exchange) in the face of a declining money multiplier or declining velocity of money. Under a gold standard, a high price level driven unsustainably high (by the boom-creating inflationary policies that Friedman references) needs to return to the sustainable level, but there is no virtue in “secondary” deflation going beyond that point. Thus, according to Hayek, the central bank should expand its liabilities H to offset an increased bank reserve ratio or public hoarding that reduces M/H or V. In yet other words, it is better to remedy an unsatisfied excess demand for money balances by supplying the called-for money balances than by putting a burden of downward price adjustment on the economy.

Overlooking Hayek’s stable-MV norm, Friedman and others have mischaracterized Hayek as prescribing only “to let the depression run its course.” Hayek did oppose cheap-money policies that distort the economy, and did counsel policy-makers not to obstruct the process of correcting the mistaken investments made during the boom. But quoting such statements doesn’t show that he said nothing else about depression policy.

It’s a question of who you gonna believe, a one-sided quoting of only some bits of Hayek by people unaware of the rest, or the full story of what Hayek wrote about depression policy?

I’m sorry that Krugman didn’t call me out by name. It prevents his readers from finding and reading the other side of the debate.

I might also mention that my article treats the question of what Hayek really said as a matter of getting the intellectual history right. I do not suggest that mischaracterization of Hayek’s position is limited to left-liberals. Indeed, as Krugman’s blog post does, my article prominently quotes Milton Friedman’s criticism of Hayek for supposed liquidationism. Friedman is no left-liberal. Thus I would never call it “some kind of liberal libel.”


Monetary theory and monetary policy in one sentence each

by Kurt Schuler August 11th, 2013 10:14 pm

Scott Sumner recently issued a paper called "A Market-Driven Nominal GDP Targeting Regime." In it he comments that

it is not clear that the preceding five economists [Milton Friedman, Bennett McCallum, Robert Mundell, Robert Hall, and Michael Woodford] would even agree on what is meant by the term “monetary policy.” Friedman and McCallum might argue that monetary policy is all about control of the quantity of money, however defined. Mundell and Hall might argue that monetary policy determines the price of money (in terms of foreign exchange, or gold, or a basket of commodities.) Woodford might see monetary policy in terms of changes in the rental cost of money (i.e., short-term interest rates). The quantity, price, and rental-cost approaches to policy have all been around for hundreds of years. And both the short-run sticky-price and long-run classical frameworks go back at least to David Hume. These differences of opinion will not be resolved anytime soon.

Here is my proposed solution: Monetary theory is about how the nominal supply of money adjusts to the real demand for money. Monetary policy is about the best way for the adjustment to happen.

Briefly, there is a demand to hold a certain amount of purchasing power as money, both in the narrow sense of the monetary base and in the broader sense of various credit aggregates. The demand is clearly not purely nominal. When currency redenominations happen and 1 new peso is made equal to 1,000 old pesos, people who kept 100,000 old pesos in their wallets will rarely try to keep 100,000 new pesos in their wallets. The demand for money is in a certain sense "fuzzier" than demand for many other goods, though, because of money's function as a store of value. If somebody were to give me a ton of apples, I would try to get rid of them immediately. I have all the apples I need right now and I don't need a ton rotting on my hands. If, however, somebody were to give me the equivalent value in money, which let us assume is $800, I might hold onto part or all of it for quite a while before spending it.

The nominal supply of money can adjust to the real demand for money through price, quantity, or quality. A frozen monetary base is an example of price adjustment: the monetary base does not change and the purchasing power of each unit adjusts. A gold standard is an example of quantity adjustment: the purchasing power of each unit is fairly stable and the quantity of units in existence adjusts. A change in exchange controls is an example of quality adjustment: tightening exchange controls when the real demand for money falls makes each unit of money less useful, reducing the quality-adjusted supply.

I think that the five economists Sumner mentions, and many others as well, would agree with my suggestion that they are trying to figure out the best way for the nominal supply of money to adjust to the real demand. Where they differ is in their proposed solutions: freezing the monetary base? Adopting a gold standard? Targeting short-term interest rates? Manipulating exchange controls? Targeting nominal GDP? One of the many other policies imaginable? Proponents of free banking would argue that discussions about "the best" policy imply a degree of knowledge that we do not in fact have, and that the pressing need is to let competing approaches work themselves out in the market so that we can discover what is best.

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