Monetarism and the US Economy
Tom Nugent's article on the US economy and monetary policy inadvertently revealed the severe shortcomings of monetary debate in the US. (Monetarism: Dead at Last?, National Review Online, 23 July 2007). Nugent refers to Wayne Angell, a former member of the Federal Reserve Board, who appeared on the Larry Kudlow show on CNBC, who said that the Fed was targeting the federal funds rate. What was really interesting was his comment that monetary growth merely responded to changes in the demand for money.
If Angell's monetary views accurately reflect those of the Federal Board then this means that they believe the money supply is passive. This comes perilously close to the fallacious post-Keynesian argument that the banks simply expand the money supply in response to changes in demand for money, a view that bears a striking familiarity to the needs-of-business fallacy. But this argument ignores the vital fact that the central bank sets reserve ratios, not the banks themselves. Therefore banks can only lend up to the maximum of their reserves and no further, irrespective of the increase in the 'demand' for loans. In plain English, the sort of monetary situation that is being discussed can only emerge where fractional banking is practised.
I doubt if many commentators realise just how frightening Angell's monetary ignorance really is. And Nugent is no better. He stated that
As Banking 101 instructs, loans create deposits and deposits require reserves. And as Economics 101 teaches, you can control the price of something (e.g., the fed funds rate) or the quantity of something (e.g., the money supply), but you can't control both at the same time.
This is a terrible mercantilist fallacy. Interest is the price of time, not money. Much of this nonsense probably comes from Keynes who argued
...that the rate of interest is the reward for parting with liquidity... It is the 'price' which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash. (General Theory of Employment, Interest and Money, Macmillan, ST. Martin's Press, 1973, p.167).
Hence the supply and demand determines the rates of interest. Twelve years earlier Ludwig von Mises described this fallacy as one of "of insurpassable naiveté". (The Theory of Money and Credit, LibertyClassics, 1981 [first published in 1912], p. 392). Frank Knight was equally scathing, writing that
It is a depressing fact that at the present date in history there should be any occasion to point out to students that this position is mere man-in-the-street economics. (On the History and Method of Economics, University of Chicago Press, 1956, p. 222).
Faustino Ballvé, a Mexican economist, made it clear that interest is not a monetary phenomenon. As he explained, if an entrepreneur
can find the money, he can have today what otherwise he must wait for until tomorrow. Thus, when he obtains a loan, he does not hire money; he hires time. The interest that he pays is the price of the advantage that he gains in having today what otherwise he would not have until tomorrow. (The Essentials of Economics, The Foundation for Economic Education, Inc., 1963, p. 45).
After all the work that has been done on the question of economics Tom Nugent gives us one of the oldest economic fallacies in the book. Unfortunately, he didn't stop there. He asked "If the economy decides to demand more money, as reflected by the "soaring" demand for it, how then does money supply matter?" This ignores another vital fact: Money is a good and like any other good, it's price (purchasing power) will rise if the demand for its services increase. But in order to demand money one must offer something in exchange. What this means is that in a progressing economy with a stable money supply general prices must fall.
Nineteenth century Britain experienced something like 50 years of falling prices. From 1875 to 1895 alone wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise. During the whole 50 year periods real wage rates rose at an unprecedented rate. The reason was rapid capital accumulation that in turn raised the marginal value of labor's output by continually cutting the cost of production. In other words, increasing investment drove up productivity and hence wages. What should be noted here is that increasing productivity also increase the demand for money. As Lord King rightly pointed out in 1803*:
...it must follow that there is no method of discovering a priori the proportion of the circulating medium which the occasions of the community require; that it is a quantity which has no assignable rule or standard; and that its true amount can be ascertained only by the effective demand [emphasis added]. (A Selection of Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844, p.72).
Lord King's observation supported Ricardo's contention that
If the quantity of gold and silver in the world employed as money were2 exceedingly small, or abundantly great, it would not in the least affect the proportions in which they would be divided among the different nations -- the variation in their quantity would have produced no other effect than to make the commodities for which they were exchanged comparatively dear or cheap. The smaller quantity of money would perform the functions of a circulating medium, as well as the larger. (John Ramsay McCulloch, The Works of David Ricardo, John Murray, Albemarle St, 1888, p. 263).
The question of interest rates, money supply, depreciation, forced savings, inflation, etc., were hot issues in the 1800s, issues that have once again arisen, mainly because the previous economic wisdom has been forgotten. For example, we are taught that lowering interest rates will stimulate output. These economists never doubted that for a moment. They also did not make the mistake of confusing such increases in output with economic growth, though they did recognise and debate the phenomenon of forced savings.
Now Lord King saw, as did his contemporary Henry Thornton, that forcing interest rates below their market rates would create an almost infinite demand for credit. (It was Ricardo who theorised that the boom-bust-cycle was generated by credit expansion). Nugent's response to this line of reasoning is to state that Japan's monetary expansion
was enormous, yet inflation in Japan was non-existent. In fact, the problem in Japan was deflation, even though central-bank-induced money supply was exploding.
The fact is that in 1994 the Bank of Japan implemented what amounted to a zero interest rate policy when it lowered its discount rate to a record low of 0.5 per cent and kept it their. What was the result? Eventually savvy Japanese used borrowed funds to buy US bonds that were yielding over 4 per cent. This arbitrage operation exerted an upward pressure on the US dollar. Obviously, in order to compete against the interest rate on US bonds Japanese businesses would have to offer a higher rate return. Moreover, Japan basically pursued the same economic policy as it did after WW I. Shortly after the armistice the boom went bust and the Japanese government responded by trying to maintain the same economic structure as prevailed during the boom. The result was about 7 years of economic misery until the financial crisis of 1927 finally rid the economy of its boom-created malinvestments.
Now if economic commentators had any historical perspective the 1927 financial crisis would have drawn their attention to the parlous state of Japanese banks. Their situation was so bad that in 1998 the Japanese Parliament cobbled together a US$500 billion rescue package to save the country's top 19 banks.
According to Austrian analysis monetary expansion triggers booms and misdirects the pattern of production, hence the malinvestments. However, it is always assumed, unless otherwise stated, that there are real prospect of profit. Therefore, to survive the malinvestments would require ever larger doses of credit. If the malinvestments are widespread and deeply embedded in the economy then even comparatively large amounts of credit might barely be sufficient to keep them afloat. This would clearly be to the detriment of other businesses. The phenomenon of 'excess' bank reserves might even appear.
Let us be clear what this means. In order to continue operating these malinvestments would be using 'cheap' credit to bid resources away from more fruitful lines of production while creating even more malinvestments. Looked at in this light the credit is not so cheap after all. A Nugent supporter might argue that if the alternative projects are more profitable then they should still be able to compete against the malinvestments. Such an argument completely ignores the discoordinating effects of inflation. There is also the generally neglected fact that Japan's national debt now stands at about 176 per cent of GDP . This in turn is gobbling up savings.
Nugent is convinced that falling prices are always a symptom of deflation. Economic history and sound economic theory have refuted this view. It is ridiculous to argue, as he did, that Japan suffered a deflation at the same time as she inflated the money supply. By definition, deflation means an absolute fall in the quantity of money. As the purchasing power of money is determined by the supply and demand for money, it follows that if demand in the form of increased output (not increased cash balances) rises faster than money incomes prices must fall. This is just another way of saying that increased productivity has driven down general prices.
It should be recalled that despite monetary expansion continuing after 1933 the Hoover-Roosevelt tax and regulatory policies gave the US economy the longest and deepest depression in its history. Finally, this topic is, without a doubt, the kind of economic problem that could not be resolved in even a very lengthy article.
*This was taken from Lord King's pamphlet Thoughts on the restriction of payments in specie at the Banks of England and Ireland, 1803