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If the central bank announces a nominal GDP growth target (Sumner's position) and sticks to it, I don't see how this is a juggling trick or destroys social bonds of trust. It seems like trust would be destroyed only by failing to stick to the announced target.


Therein lies the problem --- government sticking to a principle rule when in fact it is expediency which drives actions (thus the Hart and Zingales cite). Shouldn't public choice issues be taken into account for the analysis to be complete?



Public choice issues *are* being taken into account -- the proposal for a NGDP rule means limiting the discretion of monetary authorities. Although it would be preferable to decentralise money and banking, in the world of second best there are still better and worse institutional arrangements.

A monetary rule tied to market expectations (as Sumner proposes) seems a lot better than the monetary discretion regime we have at present. Of course, what other institutional changes would be necessary? And how can those changes be implemented given the present regime? These are genuine concerns that I don't think Sumner's spends enough time on them. Then again, he is a theorist more than a practical policy maker, so perhaps someone else needs to pick up the baton. In any case, even if Sumner's monetary rule is unsustainable given public choice issues, surely even a few years of good monetary policy (supposing his proposals are indeed good) is better than none, right?

Having said that, if Sumner is correct, then much of the recent calamity (and especially the financial crisis) may have never happened had the Fed expanded the money supply more in early '08, because back then the decline in money demand wasn't so steep. It was the failure to respond initially that intensified the problems until a crisis erupted. In other words, the demand for political expediency may never have arose if the rule had been kept to in the first place.

Hopefully I haven't misrepresented Sumner's views here!

I think Pete's saying that the power to inflate is always and everywhere discretionary, and as such is more dangerous than the possibility of secondary deflation.

But stated thus, I don't think Uncle Steve's position necessarily contradicts that, because it takes the power to inflate as given. It simply says, "given discretion, here would be a better use of it."

A pithier rendition of my reading of Pete would be:

"Monetary policy is always and everywhere a political phenomenon."

Another aspect. The interconnectedness of monetary and fiscal policies means that we are constantly being hit with second-best problems. (This gets even worse when we go beyond the policies themselves to the institutional framework.) So if you take (certain) fiscal policies as given, then what do you do about the monetary side?

For example, Social Security and Medicare (and now the new healthcare plan?) are out of control, so what is the monetary authority to do about interest rates and deficits? If they do not accommodate who will be blamed for the results? Furthermore,kill the Fed may be fine. But what if you cannot? And so forth.

This is why all policy advice needs to be prefaced by what is being abstracted from or ignored.


Sumner actually provides an example of a monetary rule that was kept to for a long time, and it was kept even in the face of economic problems. The Bank of Japan targeted a stable price level, and according to Sumner's figures, that's exactly what they got. Imagine if they had instead chosen Sumner's NGDP targeting rule, would that have produced a better supply of money? Were there any public choice issues that made price level targeting preferable? It doesn't seem so to me. What institutional arrangments enabled the Bank of Japan to keep to its monetary rule?

Although I am far from arguing that the supply of money should be handled in this way, in the world of second best there are certainly better and worse ways to do it.


Adam gets my concern correctly.

This is not a new argument by me -- look at my earlier discussion on "robust" institutions and monetary policy.

Now, it could be the case that Sumner has found the rule that binds. I must admit that I also find his story about the Fed being too restrictive both then and now to be odd -- I invited him earlier this term for a seminar and he was a great visitor, but I am still not persuaded about many of his points. However, for this conversation lets assume he is correct in his analysis of monetary policy IF it was being run by eunuchs. The problem is that political institutions are not populated by eunuchs. Here I wonder whether the policy prescription offered isn't similar to what Friedman criticized Abba Lerner for in his review of The Economics of Control --- policy as if in a vacuum without a real examination of the administrative costs of policy. And remember that both Hayek and Friedman started their careers discussing ways to appropriately management the relationship between MV=PY, but both came to argue that the only way to "win" that game is not to play it at all --- get the state out of monetary policy. Hayek's denationalization proposal follows from that sad conclusion on the state of the world.

That is what I am getting us to think about first and foremost. Then once we are thinking seriously about this (and thus questions of "end game" etc.), then I think we can revisit the technical issues in monetary policy as if conducted by eunuchs and the relationship between MV=PY in a dynamic as opposed to static setting. Once here, I think my position would be closer to Mises's discussion of the quantity theory both in The Theory of Money and Credit and also in Epistemological Problems.

We keep hearing about a second best world.

Does anyone here deny that a completely free market would be the first best, that there is no need for any monetary authority outside the market itself, that, whatever its own supply of money, it would be the optimum supply?


I share the view that it would be best to "get the state out of monetary policy." In my ideal world, private issuers of money would each have their own monetary policy, and the marketplace would pick winners and losers. However, I wouldn't expect that kind of talk from Sumner, because I do not think he believes free banking would provide a stable monetary order. My impression is that he considers central banks a necessary evil to fix an inherent weakness of the market economy.


I was thinking about your concerns when I wrote about index futures convertibility and a monetary constitution.

That the Fed has actually been trying to manipulate the allocation of credit is a very serious problem. I don't see how this shows that adjusting the quantity of base money to the demnad to hold hold it, and thereby stablizing the growth path of nominal expenditure is related to that manipulation.

The Treasury could sell govenrment bonds and use the funds to bail out any firm, finanical or otherwise, that it wants.

I do think that the recent manipulations of the Fed's asset holdings (from holding government bonds to targeted lending) is yet another reason why privatizing hand-to-hand currency and getting rid of reserve requirements are a good idea.

Peter, Thanks for the link. If we take a public choice view then here are the relevant alternatives in my view:

1. A monetary policy that creates or allows a severe break in NGDP, a severe recession, and which is inevitably followed by massive fiscal stimulus and budget deficits approaching 2 trillion.

2. Or a monetary policy aimed at 5% NGDP growth which avoids a severe recession, and keeps the budget defict at a few hundred billion.

In other words I don't see my views as being at all similar to Krugman's; I strongly oppose fiscal stimulus and think that (from a public choice perspective) the only way to avoid fiscal stimulus is with a monetary policy that keeps NGDP growing at a modest rate.


The monetary authority should do nothing in response to social security or medicare expenses. It should continue to maintain a stable growth path of nominal expenditure.

If the government can't pay its bills, then it will be cash constrained and will have to cut spending. If interest rates are impacted by budget deficits, well, that's what happens when national saving decreases.

I do agree, however, that using the monetary system to generate some money from the government (mostly through currency) is a mistake. It creates the temptation to say, why not just a little more?

This is another reason why getting rid of government currency in favor of banknotes and ending reserve requirements are desirable.

Recent experience shows again the danger of interest rate targeting. Nominal interest rates on short term and low risk assets are really low. There is plenty of "money."

That interest rate targeting makes people think that the Fed is responsible for interest rates and so to blame if debtors must pay higher interest is just one more nail in that coffin.

Using monetary policy to prevent changes in real interest rate fundamentals, can easily become catastrophic!

Index futures convertibility is not interest rate targeting. Personally, I think the Fed should pay interest on reserve balances, but peg it below the interest rate on T-bills. It should be able to say that it just follows market determined interest rates, and the quantity of reserves are adjusted to keep meet demand and so keep nominal expenditure on a stable growth path.

Thanks to Pete for raising the issue and eminding us of the important Frankel book. There is an ongoing unwinding of malinvestments from the last book, which is putting continued downward pressure on many asset prices (home prices being one example). This is the closest we'll come to an experiment to test the reflationist logic. Is there just a shortage of nominal demand, or are real factors at work?

Mario said: "So if you take (certain) fiscal policies as given, then what do you do about the monetary side?"

I wonder how much fiscal policy is influenced by an accommodative monetary policy. At first it seems that fiscal policy will be less responsible with an implicit guaruntee that it will be bailed out in a crisis, but politicians operate on short time horizons and fiscal crises usually occur with large intervals. Furthermore, politicians may not know that a fiscal crisis is looming or when it will occur. So what influence on fiscal policy would an accommodative monetary policy have? It seems to me that most politicians fare no worse an implicit guaruntee than without, since the majority will never experience a fiscal crisis while they are in office.

In any case, it's interesting to think about.

By the way, I do realise that accommodative monetary policy doesn't *just* mean bailing out the government in a crisis. I was just thinking about that one aspect.

Mario is on the mark for raising the issue of fiscal policy. Wars used to be the precipitating cause of fiscal crisis. Now the federal government is broke just trying to run on a day-to-day basis. Monetary policy then becomes the indespensible option to avoid a fiscal crisis. It is what Adam Smith called "pretended payment" to the creditors. I can't conceive of a modern empire running without a central bank. Our free banking colleagues need first to address the fiscal issue.


I am a reflationist. But I also believe that there are real factors at work. There are always necessary reallocations of resources, but I grant that there are more than usual now. I expect slow real growth and higher structural unemployment for sn extended period of time because of malinvestment.

Nominal expenditure is too low, and should be increased back to its previous growth path. "Reflation," I guess.

However, nominal expenditure targeting doesn't require that any asset price return to its previous level. Market forces can determine relative prices, including asset prices, and the compostion of demand and output.

It is just that this occurs in an environment of slow steady growth in nominal expenditures.

As I see it, it is the deflationists that must make the argument that it is 100% real adjustments and that prices (including nominal incomes) have already adjusted enough so the real volume of expenditures remains equal to the changing productive capacity of the economy.

I think this is very unlikey. My view is that productive capacity is low but real expenditure and real output is below that depressed capacity. I think the natural unemployment rate is high, but the unemployment rate is higher still.

Nominal expenditure targeting doesn't require that the level of productive capacity or the natural unemployment rate be known. Those aren't being targeted. One of the key arguments in favor of the approach is that letting goods prices adjust is the least bad option to these sorts of fluctuations in productive capicity. And output, employment, and unemployment will change. The point to avoid exacerbating the problems by creating an excess supply or demand for money.

It's hard to see how this is anything but a debate among socialists over how best to run other peoples' lives. For, if you agreed that the money supply was best left to the free market, there would be nothing more to talk about.


Thanks for the response. Let me just zero in on one point" "Market forces can determine relative prices...." How do "market forces" operate apart from expressing demand in money terms? How can monetary policy be conducted in a neutral way? In my opinion, it's an impossible task. And that is leaving aside the Public Choice issues that folks have raised. The Fed has become politicized to an unprecedented degree and much of what it is now doing is fiscal policy disguised as monetary policy.

That wasn't to say that you needn't describe the damage done by intervention, but it seems to me that you have been going beyond that, still debating what a socialist authority should do.


Market forces can determine relative prices in an environment of nominal expenditure targeting through changes in money prices. Steady growth of nominal expenditure is consistent with rising, falling, or steady prices of single family homes. Similarly, it is consistent with growing, shrinking or steady growth in the production of single familiy homes.

Of course, targeting the growth rate of nominal expenditure says next to nothing about what happens to the prices of financial assets. They depend on market forcs entirely.

Nominal expenditure targeting doesn't even try to manipulate the money prices of goods. They are free to change too. Relative prices, the composition of output, and any sort of mix between the price level and aggregate output depend on market forces.

All that is targeting is the total of the nominal spending on final goods. That creates an enviroment or framework and supply and demand handles the rest.

The reason I favor this approach is that it avoids (to the degree possible) an imbalance between the quantity of money and the demand to hold it. Adn it is based upon the judgement that the market process that corrects that for a given quantity of money--a change in all prices and nominal incomes--works badly. It works badly because prices are not perfectly flexible.

In general, I don't claim that different monetary regimes generate the same allocation of resources. Perfect neutrality? Compared to what? It is a pipe dream.

Perhaps I haven't given this close enough attention, but I still can't tell if you all are coming at this from the perspective of interventionists recommending particular interventions, or of anti-interventionists explaining why they wouldn't work.

What Bill W said here:

"However, nominal expenditure targeting doesn't require that any asset price return to its previous level. Market forces can determine relative prices, including asset prices, and the compostion of demand and output.

It is just that this occurs in an environment of slow steady growth in nominal expenditures."

Jerry's response is important. No the Fed can never be perfectly neutral. But the question is whether the damage done by it doing nothing is greater or less than the damage done by the non-neutralities of NGDP targeting. We've had this conversation before and I do think there's no a priori right solution. I (and Bill) simply worry more about insufficient MV and believe that if you get MV right, you'll not distort the relative price adjustment process in any way significant enough to worry about. Moreover, if you allow MV to fall, you'll initiate additional relative price distortions to the ones created by the boom.

It's all choices among the imperfect.

And for Lesvic: if you actually read anything but Human Action, you'd know that pretty much everyone in this conversation agrees that the first-best world is letting the market produce money.

I appreciate Steve Horowitz's clarification. I think Bill Woolsey's presentation is a perfect textbook depiction of monetary policy. But for me it leaves out all the complications. There are those in and outside the Fed who think that the Greenspan Fed was approximating NGDP targetting (at least for a time). That did not end well. To reiterate my last point: regardless of what one might think the Fed has done in the past or can do, it is clearly not attempting to be neutral now. I elaborate on some other issues with a new post over at ThinkMarkets.

"Is there just a shortage of nominal demand, or are real factors at work?"

Isn't this a false either/or choice?

Hayek argues we could and often do have both operating at once.

There or no perfect solutions here -- but you get better policy when you havr the capacity for seeing both causal processes.

Most macroeconomists are blind men who can't see the causal process of "recalculation" -- a truly pathetic state of affairs.

Final Sales of Domestic Product (aggregate demand) fell of a cliff so to speak beginning in the 4th quarter of 2008 with a year-on-year increase of 0.4%. In each of the first three quarters of 2009 aggregate demand’s year-on-year increase was negative. To put this in perspective, prior to the 4th quarter of 2008, the past 25 years aggregate demand’s year-on-year increase has averaged 5% with a low of 2.7% in the 2nd and 4th quarter of 2002 and a high of 9.8% in 1985.

Did the Federal Reserve have the ability to prevent the drop in aggregate demand? I think the answer is yes. The equation of exchange says that MV=Py, where Py is aggregate demand. Perhaps I am being naïve here, but we have had a drop in Py as illustrated in the paragraph above. V has fallen and the increase in M has not kept up to keep Py from its dramatic fall. The Federal Reserve has the power to increase M to such an extent to create hyper-inflation, so certainly it also has the power to increase M to prevent a fall in Py.

Should have the Federal Reserve prevented this unprecedented drop in aggregate demand? Rothbard would probably have answered no. As I understand, his view is that the supply of money is always at its optimal level and any increase in the supply of money greater than the increase in the supply of gold is inflationary. Therefore, he would not have supported offsetting a fall in V with an increase in M. Mises would probably have answered yes. His view of inflation is defined by any increase in the supply of money that is not offset by a corresponding increase in the demand for money. Therefore, if the demand for money increased (a fall in V) then the appropriate response would be to increase the supply of money (M) keeping Py constant and preventing inflation or deflation. Other Austrians support this position as well. Scott Sumner has argued that the trouble with the depths of the recession was not mainly due to the banking crisis but due to the fall in aggregate demand. I have found his arguments (and others) in support of a constant growth in aggregate demand convincing. Although there is disagreement on the rate of Py growth.

I think the Federal Reserve should be severely criticized for the fall in aggregate demand. It had in its power the ability to prevent the fall in Py but did not due so. Back in the fall of 2008, my concern was that the Federal Reserve was increasing M too much. The Fed had increased its balance sheet from less than one trillion dollars to over two trillion dollars. I had assumed that this would lead to an explosion of inflation. But in October of 2008, the Fed had started paying interest on excess reserves. So, much of the increase in its balance sheet ended up lying idle as excess reserves and not having the desired effect on M to prevent a fall in Py. In addition, the Fed, by lending to specific companies such as AIG and certain banks, is engaging in fiscal policy and not monetary policy. The Fed has gotten away from the traditional tools of monetary policy, which should have been sufficient to stabilize Py, and decided to experiment with all types of new innovations. These innovations have failed.


Now that you have squarely laid the egg on the table in full view on the old chestnut of free banking, how about an exposition on how it would have a) avoided a speculative bubble in US housing markets, and b) avoided the expansion of derivatives based on derivatives markets, whose collapse in the fall of 2008 appears to have precipitated the major plunge into recession?

(Oh, and just to throw in another one, does free banking also exclude having an FDIC?)


I've written a couple of papers about this that have been linked here several times. Search the Mercatus site. Bottom line: You don't get the bubble without fuel from the Fed and you don't get the problematic derivatives without the bubble. If free banking is less likely to generate negative real Fed funds rates, then it's less likely to create a bubble etc.

Why the bubble was in housing involves other matters, but even with those interventions, there's no bubble without the monetary fuel.

Jerry O'Driscoll's point, of course, draws our attention to the non-neutral "injection affects" from a monetary expansion, whether "inflationary" or "reflationary."

Real supply and demand changes, in a money-using economy, are expressed in monetary terms through individuals offering money for goods and goods for money.

Now, if the monetary authority "overlays" this market process with injections of new money (even if it "reflationary" monetary expansion), there is no way that market (relative) price signals will not be distorted to some extend by this "artificial" influence on money demands and prices for goods, capital and resources.

And this can delay or even further distort the adjustment process that is necessary for the market to return to market-based coordination following earlier monetary-induced misdirections of resources and capital malinvestments.

Richard Ebeling

DG Lesvic: I believe that most participants on this blog would agree that free banking is the first best solution, or at least be sympathetic to that idea. However, it is extremely unlikely that the government would voluntarily relinquish control of monetary policy, at least not any time soon. If the majority of economists agreed that free banking was the best policy, maybe there would be a shot, but I doubt even a quarter would support it. As long as that is the case, discussing second best policy alternatives is a productive task.

I think Richard Ebeling got it just right.

If there must be a monetary authority, it would best if it did nothing, but just left the money supply alone, whatever else happened, and even if it had changed the money supply before, to leave that change alone, and change it no more.

Any disagreement with that?


I realize that I am leading this discussion off the rails from the original post, but what the heck. So, I have read a lot of your stuff previously and just went and refreshed myself with some of the more recent rounds. Correct me if I am wrong, but I would summarize as follows.

When asked about why it looks like the US had lots of macro instability (and bubbles also) during the period when there was no central bank, you have generally responded that the problems were due to a variety of regulations at various levels that either caused or aggravated the observed problems.

Regarding the more recent events, you argue that it is monetary fuel (alone) that fuels bubbles. You also claim that the higher order derivatives also depended on the monetary fuel. This most recent bubble went into housing because of Fannie Mae, Freddie Mac, and other policies favoring housing (I did not see you mention the mortgage interest rate tax deduction, however), although as you admit, Fannie has been around since 1938, as has the secondary mortgage market.

So, before proceeding further, all readers should understand that I am a skeptic about free banking, but I also do not have "the answer" regarding what monetary policy should be.

So, on the more recent stuff, I note the housing bubble started in 1998, not 2001, as you pinpoint 9/11 as the trigger of the overly easy monetary policy. While pretty much all major bubbles have been further fueled by easy money policy, they can also expand with rising leverage, which does not require monetary expansion. It was privately owned banks that went around offering interest-only mortgages. Did they do that because the Fed or Fannie and Freddie told them to? Would they have not done so in a free banking system?

Likewise with the higher order derivatives. I do not see their emergence as having anything to do with the bubble, much less the Fed or Fannie or Freddie. The most exaggerated forms of this went on at the international level outside any regulatory framework, as with the London subsidiary of AIG that was reportedly the main international issuer of CDOs, and whose threatened collapse after the failure of Lehman Brothers seems to have been the most immediate trigger of the most extreme moment of financial crisis in September 2008. The link to the bubble was that it was when the bubble went down, it led to this pyramid to collapse.

That will do for now.

"Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound."

Those are Ben Bernanke's words, November 21st 2002, speaking before the National Economics Club, Washington D.C.

In early 2008, the growth rate in nominal expenditure was falling as velocity declined. This was probably a result of the collapsing housing bubble. Normally, as borrowers reduce expenditures to pay off debts, savers receive their money back and increase expenditures (whether on cunsumer goods or further investments). Thus the spending decline of one group is then offset by the spending increase of the other and nominal expenditure remains stable. However, this time savers received their money back and held onto it, because the bursting bubble had increased the perceived risk of investing. Thus the rate of spending that borrowers had been planning on did not materialise and many otherwise quite sound investments started to turn sour.

It seems to me a free banking system would react to the increased demand for money by expanding the supply of credit. When savers received their money back and held onto it, the banking system would reflexively produce more credit and more investment spending. Thus nominal expenditure would be stabilised by free bankers, responding day by day to changing market conditions. But instead we have a Board of Governors who meet once every month or two and decide to target an interest rate.

When nominal expenditure began falling in early 2008 in response to declining velocity, the Federal Reserve held upon their previous money growth trajectory. In the face of rising money demand, what once may have seemed easy monetary policy became too tight. In consequence, the Federal Reserve, by poorly handling the bust, set off the very deflationary spiral (or secondary recession) that Bernanke reassured the National Economics Club could not happen, not in the United States, under the watchful eye of the Federal Reserve. It wasn't until late 2008 that the monetary spigots were finally opened, and at that point a torrent was necessary to offset the incredible fall in nominal expenditure.

The Federal Reserve helped feed the bubble in the first place, and then it aggravated the inevitable recession by starving the bust. But what else should be expected by Soviet-style central planner of the money supply?

Okay ... what's wrong with this story?


Here's what's wrong with your story.

You’re confusing a greater marginal with a greater total demand for money.

This is your case, I believe: Just as a greater demand for oil calls for a greater supply of it, a greater demand for money calls for a greater supply of it.

But oil is an object and money a medium of exchange. While the supply of the objects of it, oil, apples, and oranges, determines our wealth, that of the medium of it, money, does not. We are richer with 100 than with 50 barrels of oil, but no richer with oil at $100 than at $50 a barrel. What matters is not the total number of dollars but the ratio of one dollar price to another, not that apples go for 10 dollars a box and oranges for 5, but that apples go for twice as much as oranges, whether at 10 to 5 or 2 to 1.

While a greater supply of oil renders a greater service than a lesser supply of it, the greater supply of money renders no greater service. So there cannot be a market demand for any greater number of dollars. The greater demand for money in the market means something entirely different, a greater marginal rather than greater total demand for money. With more goods chasing the same number of dollars, there will be a greater demand for each dollar, but not for more dollars.

The greater demand for money is really for more saving. So any bank "increasing liquidity" and reducing the value of savings would not be meeting but thwarting consumer demand, and be replaced by banks that would not thwart but meet the demand for a reliable means of saving.

A market induced deflation is not the problem. It is simply the market saying that it sees an avalanche coming, and wants to get out of the way; and, the counteractive policy, that it should just stand there and take the hit.

This discussion is really interesting.

Whatever the behaviour fo monetary aggregates, the goal of the Fed, which have been being consistent for at least 20 years, is to impede the process of economic adjustement by creating new bubbles as a substitute for the old deflating ones.

This goal was normally achieved by manipulating the Fed Fund rate. Occasionally, bailouts were organized. Recently, a massive multi-dimensional strategy of interventions, both fiscal and monetary, have been set out for exactly the same goal.

In my view of money, the channel by which monetary policy works is the socialization of costs. When the Fed prevents interest rate spikes occurring when malinvestment is at risk of becoming evident, it is giving cheap money to investors to convince them to keep their malinvestments running. Taxpayers, bondholders and moneyholders are on the pay side of this systematic process of investment stimulation through moral hazard and risk/cost socialization.

Monetary policy is an externality. Externalities push entrepreneurs toward wrong choices, neglecting risk and capital scarcity, distorting prices and market structures.

In such a society it cannot be expected that markets work. There is nothing like efficiency or coordination or "responsible" entrepreneurship that can be achieved. The Federal Reserve is affecting the informational and incentive constraints of market prices in order to impede the deflation of bubbles and the costly - terribly costly, after 20 years of compound malinvestment - process of readjustment.

I don't think that there exists a policy which can reestablish the necessary conditions of the market process, i.e., responsible decisionmaking by part of entrepreneurs without systematic socialization of costs, without a huge crisis.

The crisis could have been soft in 1990, less so in 2000, but now there are too many things to do to come back to a sustainable path:

1. remove excess capital and labor from non-compettiive industries such as automotive, banking and financial markets, real estate and construction sectors;
2. payback a huge amount of household, international, public debt;
3. reduce the exposition of the financial sector to maturity mismatch, risk and opaque investments, financial leverage, operating leverage and other risk factors which have been on the rise for years;
4. force banks and financial institutions to pay for their costs;
5. recalculate and readjust everything related to credit and risk (the two components of the real interest rate which have been systematically distorted by twenty years of monetary policies);
6. recover a sensible ratio between credit money, bank money and circulating money, as the monetary pyramid has been overstretched;
7. cut back consumption to sustainable path, something that after two decades of capital consumption may be sort of tragic.

The present situation is awful. The Fed has realized that the standard amount of drug has become insufficient to keep the market high, and is now trying all sorts of poisons to keep the market from returning to sanity, apparently with no or limited effects, and with massive costs in terms of credibility (ok, the Fed has never had a drop of it), fiscal deficits and all-inclusive moral hazard (now that the safety net has been expanded to cover non-bank financial institutions and private mortgage debtors).

I don't see the relevance of monetary equilibrium in such a framework. The relevant question is whether we want the market to face the consequences of a very long term binge or not, and what can be done to reduce the pain of readjustement without impeding this terrible but necessary process. So far, all the Fed has been doing is to try to postpone the adjustment by further socializing risks.

I believe that a look at monetary policy based on aggregates and not on this systematic process of moral hazard and cost socialization is inadequate to grasp the tragedy of the present monetary and financial architecture.

More precisely, I believe that there is no real policy tool at hand which can affect monetary conditions without affecting credit conditions (as whatever affects high-power money affects the bank lending channel, whatever affects this affects credit), and that the severity of the present crisis is due to real effects and to the "credit channel effect" ("the great deleveraging"), that have little to do with money, although much to do with the credit consequences of monetary policies.

I'm not rejecting (that would be overshooting: I just finished Horwitz's book and have others to read) the MET framework: I believe that V may be as important as M in intertemporal coordination, that price deflations have real negative effects, and that if banknotes and deposits were perfect substitutes (like in free banking) the credit impact of monetary injections would be much reduced.

But I believe that monetary disequilibrium is a negligible part of our problem. When you have a 50:1 leverage, when big corporations have gained profits for 10 years because of their financial subsidiaries and not because of their core businesses, when you need the savings of the third world to fund a craze of consumption lasting for a decade, it seems that exogenous changes in the demand for money are not the main part of the problem and not the main part of the solution.

I believe that the orthodox Austrian view plus the credit channel view implicit in the "great deleveraging" are theoretically sufficient to prove the severity of this crisis, and to argue for an even more severe crisis in case the Fed policy of forced out-of-equilibrium dynamic were reversed. I don't think that credit-neutral money would ease the pain of a readjustment that is both real/industrial and financial.

Sorry for the length of the analysis. If I had clear ideas I would have written less.

PS I may be slightly too much pessimistic. It's a timological trait of mine and, fortunately, not a praxeological necessity. :-D


We have had this discussion before, and I have answered your objections already.

A greater demand to hold money is more saving IF, AND ONLY IF, consumption spending is reduced. If spending is instead reduced on investments (such as stocks and bonds), then greater demand to hold money IS NOT more saving.

It is important to realise that people do not save money because they like little pieces of paper or big numbers in their bank account; money is saved so that it can be used to purchase goods and services in the future. How do you think those goods and services come about? They must be created by someone.

In the absence of instantly adapting prices, an increase in the demand to hold money depresses real output, unless it is offset by an expanding credit supply to fund investments that create the goods and services that savers plan to purchase in the future. Otherwise, when savers get to the future to spend their money, nothing has been produced for them to buy and their savings have thus been devalued.

That's the last I have to say on the matter. If you don't get it after all this time you never will.

Kelly says that refraining from spending is saving only if it is spending on consumption that you are refraining from. If it is spending on investment that you are refraining from it, it is not saving.

If the money that you keep in a bank account, rather than stocks or bonds, isn't saving, what is it? Neither consumption, investment, nor saving? Then it must be a waste of money, and, anyone with a bank balance, a fool.

Kelly, tell us that you're not holding any money in a bank balance right now, and we'll take up a collection for you, in a bank.

He says that money is saved so that it can be used to purchase goods and services in the future.

Is that all? Isn't it also saved so that the means of producing those goods and services will be available in the future, rather than lost in an avalance?

He says that "when savers get to the future to spend their money, nothing has been produced for them to buy and their savings have thus been devalued."

It isn't just their money that has been saved, but essential means of production, real goods and credit, that would otherwise have been lost in the avalance.

If Kelly wants to invest his money in the lifestyle to which the policians would like to become accustomed, that's his affair.

But, I'm saving mine, oh, pardon me, squandering it.

It must be wonderful to be able to convince yourself that inflation isn't really inflation and saving isn't really saving, for, in your own mind, at least, you can never lose an argument.

There is certainly a place for people like that, but, at the moment, I'm not too sure just where.

Let me put it another way:

If Kelly wants to set up shop in the path of an oncoming avalanche, that's his affair, but I'm saving society's precious resources and my precious credit until the avalanche has passed.

And if that isn't saving, and Kelly's investment is, put me in a booby hatch, because that's where I belong.

This discussion is like Ten Little Indians.

And then there were none.

DG Lesvic:

It would help if you learned some economics. Human Action is economics, but apparently it is so dense with information that some basics get lost.

Saving is a flow--the difference between income and consumption.

Wealth or net worth is the difference between assets and liabilities. Other things being equal, saving adds to net worth.

A shift from stocks or bonds to money is not saving. It is a change in portfolio demand for assets. Less of one sort of asset, more of another.

While an individual may be able to avoid a capital loss on risky assets by selling them and holding money, not everyone can do that at once.

When everyone tries to do this, no one avoids an avalanche.

It is possible that this very action creates an avalanche out of nothing. But it is also possible that there is one really, but everyone cannot avoid it by holding more money.

Suppose the purchasing power of money rises and so real balances are high. Yes, the real quantity of money equals the demand to hold it.

The supposed avalanche passes. Now what? When the money is spent, its purchasing power falls.

You are building a "macro theory" out of greater fool investing. We cannot all beat the market.

P.S. I think I get it. Your primary interest in monetary institutions is to allow you personally to beat the market and shift wealth from others to yourself. I don't think this is a useful criterion for the effectiveness of monetary institutions.

P.P.S. While there may be some use for a difference between marginal money demand and total money demand, it has nothing to with the market process by which the real quantity of money adjusts to the demand to hold money.

Bill Woolsey, Lee Kelly, you really need to differentiate here between the Wicksellian short-run and the Humean long-run.

The main problem with what DG Lesvic is saying is that it's grounded in the long-run. Monetary equilibrium theory is really about the short-run.

Response to Bill Woolsey

Daniel Webster defines “saving” as “preservation from destruction…from loss or danger.”

Bill Woolsey defines it as “a flow – the difference between income and consumption.”

Does that make Webster’s definition wrong?

Woolsey says “saving adds to net worth.”

No. Earnings add to net worth. Saving just preserves it.

Woolsey says, “While an individual may be able to avoid a capital loss on risky assets by selling them and holding money, not everyone can do that at once.”

But everyone can avoid setting up shop in the path of an oncoming avalanche.

He says, “When everyone tries to do this, no one avoids an avalanche.”

Even if no one could get everything out of its path, everyone could avoid putting anything more in its path.

He says, “It is possible that this very action creates an avalanche out of nothing.”

Out of nothing, he says. In other words, since those who saw an avalanche coming were wrong, Mr Woolsey and his friends, who knew better, would have the right and the duty to save them and everyone else from their folly.

In socialism, yes, but, in a free market, no. We would just have to suffer the consequences of our mistakes, without a socialist dictator to save us from them.

If there really were an avalanche, he says, “everyone cannot avoid it by holding more money.”

But everyone can avoid throwing “good money after bad,” more of society’s precious physical assets and more credit into the path of the avalanche.

He says, “…Suppose the purchasing power of money rises and so real balances are high.”

That would mean that either the supply of money has gone down or the supply of goods has gone up. OK, then what?

He says, “Yes, the real quantity of money equals the demand to hold it…”

No. Money being spent is also part of the money supply.

He says, “The supposed avalanche passes. Now what? When the money is spent, its purchasing power falls…”

No. When the avalanche has passed, production resumed, and there is more to purchase, the purchasing power of money rises.

He says, “You are building a "macro theory" out of greater fool investing. We cannot all beat the market.”

That’s right, but we can all avoid throwing good money after bad.

He says, “P.S. I think I get it. Your primary interest in monetary institutions is to allow you personally to beat the market and shift wealth from others to yourself. I don't think this is a useful criterion for the effectiveness of monetary institutions.”

Karl Marx would agree with that, but Adam Smith certainly thought otherwise:

“Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally or rather necessarily leads him to prefer that employment which is most advantageous to the society…he is led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation.”

Our Marxian friend goes on, “While there may be some use for a difference between marginal money demand and total money demand, it has nothing to with the market process by which the real quantity of money adjusts to the demand to hold money.”

The demand for saving is not for a greater supply of money, diminishing the value of saving, but for a stable money supply, preserving the value of saving.

And I would like to announce that this is not my last word on the subject. I am endlessly verbose.


What is your point, that we should keep feeding the Obama capital consumption machine?

I do believe this is probably the first time Bill W has been called a Marxist.

I know, it wasn't Daniel but Noah Webster.

And it wasn't the Marx Brothers but Karl, and Bill along with him, rejecting individual self interest as "a useful criterion for the effectiveness of monetary institutions.”


"Earnings" are a type of income. If they aren't used to purchasing consumer goods or services, they are saved and add to net worth.

In my Webster's, the definition used in economics isn't 1., but rather 3.b. the excess of income over consumption expenditures.

OK. Now that you have me wasting my time looking at Webster's Dictionary, clearly it is time to give up on this discussion.

It seems that everyone who disagrees with Mr. Lesvic is a Marxist, even Ludwig von Mises.

Mr Woolsey,

I'm afraid we're losing sight of what this was all about. As I recall, Kelly had said that money that was neither consumed nor invested but merely left in a bank wasn't savings, or, in terms of our avalanche, money that wasn't thrown before it wasn't saved.

All I've ever tried to say was that inflation was inflation and saving was saving.

In simple terms, if you're capable of them, was that right or wrong?

If you're inflating the money supply, isn't that inflation?

If you're saving resources, isn't that saving?

If you're saving credit, isn't that saving?

If you're saving money, isn't that saving?

Why have folk forgotten about not feeding the trolls?

I cannot believe you waste your valuable time on this 'Lesvic' creature.

His 'comments' here clutter up the real discussion and make it tough for readers to follow (Lesvic = negative externality)

And I lost sight of what this was all about.

Mr Woolsey, would you continue to feed the Obama capital consumption beast?

And, Professor Horwitz, I'm glad that you left Bemused Onlooker's insult in. It doesn't bother me in the least, and no such insults ever bother anyone with any pride in himself.

And apparently they don't bother you either, except when they're delivered with wit and style.

And when they're deserved.

"What is your point, that we should keep feeding the Obama capital consumption machine?"

Certainly not. However, I disagree with the idea that monetary expansion is necessarily doing that.

The debate between Rothbardians and monetary-equilibrium proponents is really quite complicated. I don't think we can do it much justice in this thread.


Does anyone want to go back to the original point?

I'm not so pessimistic as others I think that something like this is likely to take place through competition between state. That's how the gold standard came about too. The state that has the closest to a proper monetary equilibrium will be the one that financiers will want to hold short-term debt in. So, in some cases there will be a great interest in doing it right.

Current wrote,

"I disagree with the idea that monetary expansion is necessarily doing that."

That it is feeding the Obama capital consumption beast.

But that is its specific purpose, to keep its victims in place.

To add to my last point...

The main reason that velocity declines in a recession isn't that people need more money for immediate use. Rather it's a matter of security, they must protect themselves against a worsening of the situation.

Now, if no one really believes the monetary authority then that won't work. Even if the monetary authority act reasonably further recession will come about anyway. They will have to take extreme measure to prevent the velocity decline.

However, if an NGDP rule is believed then that won't happen. Most people won't change their behaviour because they will see the recession as transient.

So, NGDP rules will probably only work *at all* if they are believable. That is, if political factors really don't play much of a role.

I don't know if that can ever be achieved without free banking.


The declining velocity of money is not the problem but a symptom of it and an essential part of the solution.

The problem is that there is always attrition in the market, and the need for new investment, capital, and savings. The need is even greater now than normally, for an abnormally large amount of capital has been squandered.

To replace it requires an abnormal amount of saving. And since a declining velocity of money is a corollary of an increasing rate of saving, that is just what is needed now.

This whole subject is fairly new to me, so, with apologies, here is the result of my improving understanding of it.

A market driven deflation is not the problem. It is a symptom of the problem, and the solution. There are two stages to the real problem. First, there is the inflation induced misallocation and squandering of capital, and, secondly, the politicians’ reaction to it, blaming not themselves but the market for the consequences of their interference with it, and demanding more interference to alleviate the problems created by the first one. So the market must not just recover from the first wave of destruction but avoid the next one.

Deflationary saving is the means of both. It is firstly the market saying that it sees an avalanche coming, and wants to get out of the way, and, secondly, its means of reaccumulating the capital needed for the recovery, when and if the opportunity for it arises.

Just as the deflation is the market getting out of the way of the coming avalanche, the counter-deflationary policy would have it just stand there and take the hit.

And while the deflation is the corollary of the saving needed for new investment, the counter-deflationary policy would cut off the saving, and the new and better investment, for the sake of continued spending on the old and ultimately unsustainable investment.

In summation, the recession is not the problem but the solution, a curative process, purging the system of bad investments and facilitating new and better ones. Just as the inflation was the means of denying the preferences of the consumers in the first place, the deflation is the means of reestablishing them. And since there cannot be a complete recovery until that has occurred, the recession must be allowed to run its course, and the market find its bottom. Keeping it from hitting bottom just keeps it from starting back up again, prolonging and deepening the agony, and turning a recession into a depression.

Thank you for your indulgence.

Ok, I'm not sure if this discussion has broken down at this point, but I have a question. Given a Federal Reserve board and given a fiat currency and all that entails, what is the best way to inject money into an economy? I understand that it will entail distortions no matter how it is done, but surely there are better and worse ways. Most developed countries have settled on creating government debt and then monetizing it through OMOs. By screwing with interest rates, they mess up the capital structure, so is there a way that would not affect the interest rate? Would direct transfers to people be better? Would tax reductions be better? I think that the broader you can make the injection, the better off you will be. The worst case would be to have the Fed buy one specific good as it's monetary policy, since that would have tremendous distortions through Cantillon effect, etc. If anyone knows of any articles on this topic I would really appreciate a recommendation.


Even buying consumer goods distorts the capital structure because it alters the distribution of wealth.

DG Lesvic,

As I said earlier, I don't think I can convince you in this thread. It's too small a space. I used to hold your view, and it took a lot of reading before I changed it.

But, maybe I can make you doubt some of what you're saying....

If you saw through a plank of wood then sawdust is thrown into the air, and make people cough. But, when the plank is intact beforehand there is no sawdust in the air. Also, when the plank is in two pieces afterwards there is no sawdust in the air. That doesn't mean that there is no sawdust in the intervening time.

The same is true of monetary policy. We must differentiate between long-run and short-run effects. In the long-run any amount of money serves the needs of society, so long as decimalization allows for it to be split into small enough units. However, in the short-run a change in the quantity of money has distinct effects.

For example, if the quantity of money is increased from X to 2X then that requires money to be injected at some point. It drives the Cantillon effect and account falsification effects. It requires entrepreneurs to change many prices. This is the "sawdust" and it's all damaging. The same is similarly true if the quantity of money is reduced. It is also true if the reduction is driven by an increased desire to hold money.

I was suggesting purchasing consumer goods as the worst case scenario, because it would almost assuredly cause malinvestment in whatever good(s) was bought. My intuition is that if the government wanted to increase the money supply by $300 million that a good way to do so would be to just to hand everyone in the country $1. The ratio of capital to consumption goods wouldn't necessarily change, the interest rate structure wouldn't change nearly as much as the government buying short term debt, and relative prices wouldn't change to terribly much. On the other hand, a one time tax reduction would reduce the deadweight losses in the short run, but if you follow Ricardian Equivalence, then buying government debt should have the same effect.

I post under my real name here because Boettke doesn't like screen names.


I don't see where you're disagreeing with me.

I repeat:

The inflation denies the preferences of the consumers and the deflation reestablishes them.

And that is precisely what needs to be done.

I think that sums it all up.


Every intervention in the market is completely counterproductive, bringing about the exact opposite result of what was intended.

And, by the way, if I'm really so ignorant, then so too are Boettke and Ebeling, and Mises and Rothbard, for I'm really just restating their position.

With apologies, here, I think, is a little better statement of my position.

The recession is not the problem, but a symptom of it, and the cure, liquidating mistakes and facilitating recovery from them.

Deflation is a corollary of saving, and that is just what is needed, especially during a recession, and with more destructive policies on the way, saving capital from the oncoming avalanche, and for recovery where opportunity appears. And, the more saving, the more opportunity, the more deflation, the more recovery.

Whereas the deflation gets the market out of the way of the avalanche, the reinflation keeps it there, and, the deflation is essential to recovery, the reinflation cuts it off, maintaining wasteful spending, and leading to a greater collapse later on.

A recession is the reestablishment of consumer preferences. And since there cannot be a recovery without it, the recession must be allowed to run its course and the market find its bottom. Keeping it from hitting bottom just keeps it from starting back up again, prolonging and deepening the agony, and turning a recession into a depression.

I'm going on vacation for a week so I won't be able to write much more on this.

I'm sure we'll discuss it in the future.

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