Critique of the Fed in The New Republic

I just came across this nice little piece by Alvaro Vargas Llosa in The New Republic.  Vargas Llosa uses the Liberty Dollar raid to ask why we need a central bank in the first place.  The comments are pretty vigorous, with what appear to be a good number of Ron Paul supporters who know enough about Austrian monetary writings to be dangerous. 

The biggest confusion among the commenters is not distinguishing between "free banking" and a 100% reserve gold standard.  Some of those defending getting rid of the Fed make the usual weak arguments that "any supply of money is sufficient" as long as prices are free to move.  As I've asked before, why doesn't that mean inflation is harmless?  If we can't have too little money because prices can always "just" adjust downward, how is it that we can have too much if prices will always "just" adjust upward in a free economy?

The other confusion is blaming Vargas Llosa for being inconsistent in arguing that inflation was responsible for the crash in 1929 but that the Fed's allowing the money supply to fall dramatically in the early 30s was responsible for turning a crash into an extended depression.  That's not inconsistent if you approach it with a monetary equilibrium perspective where the goal is to keep the supply of money equal to the demand to hold it at the current price level.  In that view, not all expansions of the money supply are inflationary, and especially not when the supply has fallen 30% in a few short years, requiring a reflation.  Such a view is compatible with inflation in the 1920s causing the crash and deflation in the 30s making it worse.

In any case, it's good to see a moderate-to-liberal magazine like The New Republic take up this issue.  As I recently argued, the left ought to take the critique of central banking more seriously.

Comments

[matthew mueller]

Professor Huerta de Soto was right! There are Austrians who are making these sorts of arguments. His book "Money, Bank Credit, and Economic Cycles" has a great chapter on Austrian economists who make the "monetary equilibrium" argument in addition to other dubious claims.

Before I continue, I want to stress that I am not attacking the work or person of Professor Horwitz, just the arguments. Now the "any money supply is sufficient" argument is more subtle than you make it out to be. I remember running across this argument in Rothbard's "They Mystery of Banking." According to Rothbard, inflation has no place in the any money supply is sufficient argument. That is because the point he was making is that any INITIAL ENDOWMENT of money is sufficient for an economy. The problem arises when money begins either contracting or inflating -- that is when distortion occurs.

And the monetary equilibrium argument, according to Huerta de Soto is specious in the sense that any increase in the supply of money creates its own demand. You cannot create more money to satisfy a higher demand because that new increase will create an entirely new demand.

Now I am by no means a monetary expert, and if you want to win this argument then just go "technical." These are just some things I wanted to point out.

[Osborne]

I'm intrigued by your critique of the "any supply of money is sufficient" argument for the gold standard. I've heard Joe Salerno persuasively make that argument, so I'm surprised that you consider it weak. In response the question that you ask ("If we can't have too little money because prices can always 'just' adjust downward, how is it that we can have too much if prices will always 'just' adjust upward in a free economy?"), couldn't one argue that the that problem isn't too much money, but when new money is created "out of thin air" by the Fed, devaluing existing dollars? When prices adjust downward due to an increase in the supply of economic goods, the value of a dollar in terms of purchasing power doesn't change.

[Steven Horwitz]

Matthew: I've read the De Soto chapter in question, and his earlier work on this topic, and I think he's as wrong as you think he is right! It would indeed take us on a technical detour to work through it. The easiest answer is to read my 2000 book, especially the chapter on monetary equilibrium. Bottom line: a free banking system based on fractional reserves of some commodity has every incentive to respond to increases in the demand to hold money by supplying more. That increase in supply does not in turn increase the demand for money because it goes into the money holdings of those whose demand to hold has not been satisfied. I think part of the confusion here is that you are not seeing that:

1. the demand for money is a demand to hold real money balances, not spend money

2. there can be a difference between actual and desired money holdings.

Osborne: Your last sentence gives away the game. I totally agree that when economies produce more, or produce more efficiently, prices *can and should* fall. But that is not deflation, or at least not "monetary deflation." The reason that process works, as I also explain in the book, is that it is not an economy-wide reduction in prices. Prices fall in specific times and places as individual entrepreneurs lower their output prices in response to lower costs.

Compare that to a deficiency in the money supply, i.e., an excess demand for money. In THAT case, the downward pressure on prices is coming on all goods (though not necessarily equally) *just as it does during inflation.* Rothbard and those who agree with him argue explicitly that in THIS situation, prices will "just fall" to adjust to the "too low" nominal money supply. Or alternately, should the banking system produce "too little" money, prices will just fall to adjust with no problems to economic coordination at the micro level. If that's true, why isn't it equally true that if too much money is produced, prices will "just rise" to adjust to the new higher nominal money supply with no ill effects? The monetary equilibrium view is that ALL money-side induced adjustments in the price level are problematic and will disrupt micro coordination.

The key is to distinguish between goods-side downward pressure on prices (your last sentence) and money-side pressure (monetary deflation - or an excess demand for money). The latter is the situation faced in the early 1930s and *even if markets were perfectly free* would have required a painful downward adjustment in prices.

These are very short and insufficient answers to very good questions. I'm happy to say more if you want.

[tom]

"Some of those defending getting rid of the Fed make the usual weak arguments that "any supply of money is sufficient" as long as prices are free to move. As I've asked before, why doesn't that mean inflation is harmless? If we can't have too little money because prices can always "just" adjust downward, how is it that we can have too much if prices will always "just" adjust upward in a free economy?"

I suppose one could say that whatever the money supply is currently, it is sufficient to handle all transactions necessary. But just because one would argue that holding the money supply constant is sufficient to handle all transactions, that would not also mean that changes in the money supply would be harmless. In fact why would one argue the benefits of a constant money supply if it was also held that there were no harmful effects of a expanding or contracting money supply. Even if prices are free to adjust, the adjustment process is not instantaneous or without harmful effects.

[Josh H]

The point about differences between money-side and goods-side pressure on inflation is interesting. Perhaps, though, the biggest problem with inflation today is that the government and those close to it get the new money. If money became more valuable due to increased demand (instead of extra money coming out of a central source) wouldn't the gains be distributed differently?

[Bogdan Enache]

"Rothbard and those who agree with him argue explicitly that in THIS situation, prices will "just fall" to adjust to the "too low" nominal money supply. Or alternately, should the banking system produce "too little" money, prices will just fall to adjust with no problems to economic coordination at the micro level. If that's true, why isn't it equally true that if too much money is produced, prices will "just rise" to adjust to the new higher nominal money supply with no ill effects? The monetary equilibrium view is that ALL money-side induced adjustments in the price level are problematic and will disrupt micro coordination."

Prof. Horwitz, I think your question frames the whole problem very misleadingly.

After an inflation wave prices will, in the end, adjust to the new higher monetary supply. Why are there any doubts on this ? Isn't this what the quantity theory of money teaches us ?

But the real problem is all together different. Inflation produces an inter-temporal misallocation of capital across stages. As Machlup summed up the Austrian Business cycle theory : the cause of the cycle is monetary but its effects are real. Consequently, in the bust stage of the cycle the inflation induced lengthier capital structure will be terminated, a process that will unfortunetly but necessary lead to lower productivity and welfare in the economy.

Now, can we identify an equivalent phenomenon taking place in the case of monetary deflation ? I think the answer is no. Let's say we burn 20% of the current money supply, will that lead to a chain business-cycle reaction? No doubt about, some people will be hurt in this process, but I don't see how the monetary deflation in question can lead to a inter-temporal misallocation of resources across capital stages causing a systemic recession simply because the deflation does not trigger a forward looking inter-temporral discoordination of capital investment. How could it do this ? What is it to invest if now we have 20% less monetary units. The real effect that Machlup (paraphrased by me) talked about are not the same in the case of inflation and deflation.

[Steven Horwitz]

Actually Bogdan, I DO think there is a parallel process during a monetary deflation. I have an entire chapter on that in my book, but you might also see Robert Greenfield's "Monetary Policy and the Depressed Economy" for a longer treatment. Short version:

With money in short supply, money users restrict their purchases to accumulate cash balances. This reduction in spending means that others see reduced incomes, which reduces their ability to spend, and so on. If prices could fall immediately, smoothly, and perfectly, none of this would matter, but they do not. As any good Mengerian knows, this is a process through time. And there are reasons to believe that prices are indeed "sticky" moving downward when the pressure is from the money side and thus economy wide. The result of the slackened demand in individual markets with prices not immediately adjusting is excess supplies of goods AND LABOR. Firms can't sell their goods and workers and capital are unemployed. Until and unless those prices adjust downward, which they eventually do, we have a recession/depression.

It's not an Austrian cycle story, but it's another way monetary mismanagement by a central bank can cause havoc. We don't see it as often because central banks are more prone to err on the side of inflation, for obvious gov't finance reasons.

Note that this is, however, a kind of intertemporal discoordination. Producers have assumed that people will be buying a certain amount over the course of the future. With the excess demand for money, current sales slacken, leaving producers with unintended inventory build up. One could see this as a form of "forced investment" analogous to the "forced saving" of the inflationary/Austrian cycle story. They thought they had their inventory/stock on the shelves ratio right, based on the interest rate signal, but the shortage of money makes that expectation wrong - intertemporal discoordination. This also suggests that as the economy recovers, employment may lag as producers first try to draw down inventories before fully stepping up new production.

In any case, there is indeed a parallel story to the Austrian cycle theory to be found in deflations. It has a long and noble lineage among monetary theorists, especially the pre-Keynesian American monetarists. It's good, solid monetary theory.

BTW, going back to Matt M for a second, one of the Austrians who (listen for De Soto gasping...) who believed in the monetary equilibrium approach was......... Ludwig von Mises. At least the Mises of *Theory of Money and Credit*.

[G]

Steve,

What do you think of the overall effect of Ron Paul's candidacy on monetary debate? Obviously, most Paul supporters are going to know enough to be dangerous, as you've noted, if for no other reason than we can't all be economists. Paul himself does not completely explain Austrian monetary theory in his speeches, as he surely knows that would be futile. His supporters who are interested enough in Austrian theory to understand it completely can certainly look it up for themselves (I have).

On the other hand, I doubt any truly intellectual debate on monetary policy has ever occurred on the layman's level. I can't imagine it would start now. I guess the question is, what is the causal relationship of different group's adoption of ideas? Paul's goal seems to be: Idea->Populace->Politics->Intellectuals

All too often however, the relationship appears (at least to me, and I believe Hoppe) to be, Idea->Politics->Intellectuals->Populace.

Come to think of it, the obviously-dispersed knowledge of monetary theory and the obvious ignorance of the voting masses should make banking and money an area which should be left alone by government for Hayekian reasons. I simply can't see how a democratic government could make a rational decision on the matter (or any matter, but thats another story, heh).

[Steven Horwitz]

Very good question G. I think there's an upside and a downside to Paul's candidacy with respect to Austrian monetary theory.

Upside: it has people talking about questions and issues they might not otherwise, and it leads people like you to do some reading and learn about it. The fact that the New Republic published Vargas Llosa's piece is evidence of this upside.

Downside: I think there are two.

1) Of lesser importance - I think Paul's own views on monetary policy are sometimes plagued by the faults of the Rothbardian 100% reserve view, as the debate in the comments section at TNR and the one here illustrate. But that's fairly trivial in the big picture.

2) The much bigger downside is that too many people equate legitimate academic/theoretical/historical criticism of the Fed with the worst sorts of anti-Semitic conspiracy theories etc.. Some of that is in the TNR comments too, and if you read some lefty blogs who have been covering Paul's candidacy, you'll see them immediately link his monetary policy views to the worst of the nativist/creepy right. For me personally, as someone who has written a ton on the reasons the Fed is a bad institution and who is also a self-identified Jew, I find that interpretation by the lefty blogs to be offensive on several levels. And strikingly anti-intellectual - as if there aren't any legitimate criticisms of the Fed. That's why the TNR piece is so helpful.

And, unfortunately, Paul has attracted support from some of those same creepy corners of the right wing who probably DO like his monetary policy because it matches their conspiracy theories (and perhaps their anti-Semitism). Let me be clear that I do NOT blame Paul for this, as I have no evidence his criticisms of the Fed are anything but the legitimate ones above. But it is surely a downside of his campaign that in shining a light on those important issues, he attracts a few very unsavory moths and thus enables his critics to dismiss the legitimate arguments via a fallacious guilt by association.

It's a problem that Austrians have always had to face when we've talked about the problems with the Fed and the rising profile of the Paul campaign makes it a little tougher.

[Bogdan Enache]

As you anticipated, I certainly agree that fallowing the deflation it will take some time for prices to adjust, the more so in the case of an unforeseen monetary deflation. Moreover, as in the case of inflation, a monetary deflation cannot have uniform effects on the price structure and different markets so there is certainly a process of adjustment here.

But from your comments above, I tend to think that you overstress the stickiness of prices due to time and disequilibrium expectations in a largely free market economy. There are significant incentives for produces to move fast to adjust prices in a competitive environment where their cash balances have increase in real terms fallowing the deflation.

On the other hand, the macro parameters like interest rates will adjust presumably even faster, so again there are good reason for this micro-discoordination produced by a monetary deflation to be swift and largely harmless and with no long term distorting impact on the capital structure of the economy.

Thank your for the references. I will keep them in mine though I don't think that I'll be able to access them any time soon for logistical reasons.