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Pete raises a totally legitimate set of questions. Over on the other thread, I responded to a commenter's question along the same lines by saying:

"Your latter point about giving the Fed the power to respond to the secondary recession being the very same powers that can be abused is *absolutely right*. That's the dilemma of the world of the second best. The power to prevent deflation is the power to generate INflation, as the last 9 months have demonstrated amply."

So yes, Pete, you're right: given the current institutions, we do face a real dilemma. The powers we might like the Fed to have to pursue what we think is the first-best policy rule are easily used to do all kinds of bad things. So when we are stuck giving advice to the Fed, what do we say?

I think we use our best judgment in the particular historical circumstances we find ourselves. For example, it might be true (might be true...) that some sort of Friedman growth rule suitably constitutionalized would work "well enough" in normal times. (I'm not convinced, but it's not silly either.) But in extraordinary times, we might be willing to risk the downside of more discretionary powers if we think the need to respond beyond the constraints of the rule is great enough. Of course, now we're in Higgsian ratchet territory as well.

Was last fall such an example? That's a matter of judgment, not a priori theory.

My own view is that there was some risk of a severe liquidity crisis and the Fed was right to run M up to some degree. I think they way over-did it (and compounded the error by paying interest on reserves) and now we're faced with severe inflation dangers ahead.

The problem is that I don't see any obvious way out of the dilemma that the world of the second-best poses for us. You're asking the right question though.

Scott Sumner on long and variable lags:

I linked to the same Mulligan post at Scott's blog, but he seemed perplexed at the suggestion that monetary authorities might not be able to produce inflation. Scott's hobbyhorse is having the Fed target expected NGDP growth. He doesn't really talk much about the motivations of Fed behavior and just thinks they're well-intentioned but operate based on mistaken conventional wisdom, which is actually contrary to mainstream textbook theory. The idea of deferring to the wisdom of NGDP markets makes sense to me though.

The problem is the alternative. Uncontrolled deflation would be bad. Eventually, I am sure that the Pigou (real balance effect) would move things out but in the meanwhile things could get pretty rough. However, it is important point out that we might not want to do anything if average prices -- as measured in some suitable way -- began to decline just a little.

Look, when you are in a mess caused by bad policy you just try to avoid total disaster. This is not fine-tuning. The lags will be there; there will be uncertainty. Pressure groups will want more than just the avoidance of deflation. A Fed which gets us into a mess in the first place may not have the guts to resist.

But if I were asked what the best policy is after the recession has set in I would agree with Steve Horwitz, et al. Whether it will be followed, I do not know. Luckily, right now we don't have to worry about deflation so we can concentrate, so to speak, on letting the adjustments happen.

If I'm not mistaken, there in his later years Friedman actually endorsed free banking / the denationalization of money.

Let me google search to confirm that.

Pete writes:

"Milton Friedman moved from trusting the policy makers in control of acting on the monetary rule, to advocating that monetary policy be entrusted to a computer."

Larry White:

"Friedman later moved in Hayek’s direction (Friedman 1987, Friedman and Schwartz 1986), reconsidering his own earlier skepticism toward private currency"

Friedman also openly expressed this sentiment in interviews from a later period.

public choice issues are legitimate, but clearly not central for ability of central banks to manage and plan economy. Central problem is that if we accept that business cycle is fundamentally created by inter temporal misscoordination by favoring artificially more roundabout projects, deflation is quite possible an natural effect of the correction of the past mistakes. There is nothing to be corrected.

Production structure must shrink in order for ratio consumption-production based on real time preference of the public to be reestablished. Before you ask whether you can believe to central bank to fight secondary depression you must ask why "secondary" depression should be fought in the first place? If artificial lengthening of the production structure was cause of the boom, then any attempt to avoid deflationary correction by infusing additional credits, will sow the seeds of future misscoordination. By which magic only "secondary depression" credit inflation have no real costs in terms of disturbance in future structure of production? What is praxeological basis for that belief? What is the praxeological difference between "primary" and 'secondary" recession?

Only answer Steve and George gave to me on my question how millions of rational individual decisions to hold cash (causing deflation) translate into collective macroeconomic "failure" of deflation that needs to be addressed by monetary policy, was that people are not always rational!!! So, monetary policy of pumping additional credit inflation in recession is actually correcting the market failure of people not accurately predicting future developments.

But, this is quite unconvincing. Notwithstanding obvious problem of why would we believe to central bankers to KNOW future events any better than anyone else, and to be able to correct irrational hoarding of the public, (specially taking into account that they have caused the cycle in the first place, that is if we believe ABT), how the same people became irrational only in secondary depression, and not in boom, and not even in "primary recession"? How do we know that peple are irrational in secondary recession whatsoever? Why if they are completely right in their scepticism? You are taking for granted that always when we have secondary depression this is because of irrationality of the public.

So, main question here is not public choice, but epistemological limitations of central bankers and theorists, claiming they know better what the optimum level of capital investment and spending is then what real time preferences of the public reveal.

Nikolaj writes: "Only answer Steve and George gave to me on my question how millions of rational individual decisions to hold cash (causing deflation) translate into collective macroeconomic "failure" of deflation that needs to be addressed by monetary policy, was that people are not always rational!!!"

I must insist that you stop making this claim without evidence to back it up. Can you show me where I said "people aren't always rational" was the reason that a lot of people trying to hold more money can lead to a Wicksellian rot that monetary policy can prevent?

You're welcome to disagree with my views, but please stop making stuff up about what I have and have not said.

Dear Steve,

on the previous threat you wrote:
...even in an unhampered market, prices don't instantaneously and perfectly react to changes in demand and supply. There is a discovery process that involves lags/stickiness. If you grant that, then the decision by many market actors to hold more money by reducing expenditures can lead to a period of economy-wide excess supplies as prices and wages don't immediately and perfectly fall. Nothing mystical there, just the imperfect market discovery process that Austrians have talked about since Menger.

Now you might believe that those imperfections are quickly remedied and you might believe that there are costs associated with adjusting the nominal money supply in respond to changes in money demand, so that you might argue, empirically, it's better to let prices fall than to adjust the nominal money supply. That's not an unreasonable position. It's not necessarily a priori wrong, but I do think it's empirically-historically mistaken."

So, in arguing for issuing additional fiduciary media to fight deflation, you singled out "imperfections" on the market associated with people holding more cash than it would be optimal. You criticized my assertion that spontaneous adjustment should be allowed, because credit inflation was in your view more appropriate way of dealing with those imperfections/irrationalities.

If people were really rational when holding amount of cash consistent with deflation, "correction" by monetary policy would not be necessary at all! People are irrational ex definitionem if rate of time preference revealed in their free action should be altered by credit inflation, in order for "economic optimum" to be established.


The secondary recession is not the product of the market, but of a central bank's control of the money supply. If we had free banking, then an increase in the money supply would occur automatically when the demand for money rises. In other words, the secondary recession is not a "spontaneous adjustment", but a product of a centrally planned monetary policy.

Horwitz and Selgin are merely proposing that central banks emulate what would occur in a free banking system. Suppose, for example, that the Federal Government controlled the price of gasoline. While this would be an entirely objectionable way of pricing gasoline, the more closely gasoline emulated the free market price, the less the economy would be stricken with shortages and surpluses.

Steve Horwitz,

Thanks for taking the time to respond in this and the previous thread. I was highly critical of the suggestion that monetary expansion should tackle secondary recessions, but you have won me over to the otherside.

Isn't that great!? Who says you can't have productive debates on the internet.

Of course, whether a central bank should tackle a secondary recession ought to be considered case by case, because a central bank's ability to respond quickly and free of political pressure is of prime concern. In some circumstances, a secondary recession might be a lesser evil than an empowered central bank closely allied to government.


I suppose that you would object as much to government created shortages as you would surpluses. Would you call a long queue at a gas station a "spontaneous adjustment" because of a shortage created by government price controls? Although, in a sense, it surely is, I don't suppose it would be the kind of spontaneous adjustment that you would want to run its course.

It seems to me that you desire to let a secondary recession run its course is little different.

Market imperfections are not the same as human irrationality. Humans can be rational and markets imperfect at the same time.

Second, I have NEVER said that people are holding more "cash than is optimal." I don't know what the optimal holding of cash (or money more broadly) is. I have simply said that problems arises when people *want* to hold more money than is currently available. I have made no claims about optimality.

Once again, you attribute to me positions that I do not hold. I don't know whether there's a language problem here or whether you are so befuddled by the notion that an Austrian who supports monetary freedom could believe that some increases in the money supply are not inflationary that it causes your ability to interpret arguments to short out.

Whatever the explanation, I must tell you that I've about reached the limits of my patience in continuing this discussion in good faith. Again:

I have never said that the public's desire to hold more money at any time under any circumstance is either "irrational" or "non-optimal." I have simply said that IF the public wishes to hold more money than is currently available, it will have negative consequences for the economy as a whole if it is not responded to with an increase in the nominal money supply.

I have also said that, given the second-best world of central banking, this is what a central bank should TRY to do, although I have been skeptical about whether it can and and what the consequences of it trying to do so might be.

I have also said that a free banking system is desirable, among other reasons, because it would provide that additional nominal supply through the market process.

I have never defended central banking or central planning of the money supply, nor have I presumed to know better than the public how much money they "should" hold. Attributing any of those positions to me is an utter misrepresentation of my views.

"My own view is that there was some risk of a severe liquidity crisis and the Fed was right to run M up to some degree. I think they way over-did it (and compounded the error by paying interest on reserves) and now we're faced with severe inflation dangers ahead." - Steve

It seems to me important that the Fed increase the money supply using only credit expansion (to match the increasing demand for money, i.e. savings). But it is my understanding that some of the money created recently has been distributed like a gift. With no obligation to pay off a debt, the long run deflation that ordinarily follows credit expansion will not occur, and its consequences will be no different from counterfeiting.

Steve says:"I have never said that the public's desire to hold more money at any time under any circumstance is either "irrational" or "non-optimal." I have simply said that IF the public wishes to hold more money than is currently available, it will have negative consequences for the economy as a whole if it is not responded to with an increase in the nominal money supply."

What does it mean "more than currently available"? You mean, "more than it takes for production and prices to not decrease"? But, that's entirely different thing.

Further, "negative consequences" for economy you are talking about are temporarily decreasing level of spending and investment, because of increased cash holdings. By the same token, you can say that increase in investment of only 10% in the boom has "negative consequence" for the economy as well, because it would be so nice if investment would increase, say, 100%. But, that doesn't prove automatically you should inflate credit 10 times more to achieve desired 100% increase in investment.

If decisions of people to hold more cash in recession are rational (as you now emphatically confirm they are), than social rate of time preference revealed by those free decisions is optimal as well, and thus deflation and production shrinkage stemming from those decisions are also optimal, and all attempts to change that by additional supply of credit are clearly misguided measures, and can only cause further misdirection of capital and new boom/bust cycle, and actually delay the natural process of recovery.

If additional credit supply is right thing to do, than whole previous chain of argument falls apart, together with initial assumption of rationality of people's choices.

That's the problem.

Lee Keley,

increase in demand for money is not the same thing as increase in saving. If it would be so, then you could increase capital stock indefinitely by simply increasing supply of credit. That's the problem, because whole this approach is based on implicit assumption that creation of fiduciary media (otherwise thought to caused misdirection of capital artificially lowering itnerest rate) in recession somehow increases real capital formation, instead to start off new artificial cycle and delay recovery.

Nikolaj says:

"If decisions of people to hold more cash in recession are rational (as you now emphatically confirm they are), than social rate of time preference revealed by those free decisions is optimal as well, and thus deflation and production shrinkage stemming from those decisions are also optimal..."

And herein lies the problem. What I am concerned with is making sure that the banking system provides the funds for investment that match the public's willingness to save, thereby keeping the natural and market rates synchronized.

If the public starts to hold more money, specifically *bank liabilities*, they are thereby increasing their savings. This does indeed mean a reduction in the natural rate and the appropriate response of the banking system is to *increase their lending and provide the funds for investment to match that increase in savings*. They can only extend their lending by moving down the demand for loanable funds curve and lowering their interest rates, thereby matching the lower natural rate coming from the increased savings.

You seem to be assuming that the holding of additional "cash" is in the form of outside money that provides no funds to the banking system. That's true if people hold money in the form of gold or FR notes today. But if they hold their money in the form of bank liabilities, they are engaged in savings which needs to be matched by new funds for investment. If not, then we have intertemporal discoordination of the opposite sort of inflation.

Of course all of this is laid out in my book...

In any case, this could be where our disagreement lies. And it's one reason free banking is to be preferred to both central banking and other systems: if people choose to hold more bank liabilities at any time, the banking system responds appropriately. That's not true under central banking. And with 100% reserves, the only way people can hold more money is through the painful process of deflation as noted earlier.

An increase in the demand for money *in the form of bank liabilities* certainly is an increase in the supply of loanable funds, or saving. If I increase my checking account balance, I am giving the bank control over those funds with which they can now create more loans.

Why do you think banks want to increase the total quantity of deposits they have? That is the public's saving, with which the bank can then create more loans.

As I said above, if the money holding takes place through either federal reserve notes or through gold in a free banking system then it does not comprise saving in the sense of supplying loanable funds. But if it's bank liabilities, it sure does.

"increase in demand for money is not the same thing as increase in saving. If it would be so, then you could increase capital stock indefinitely by simply increasing supply of credit."

And here N's confusion is clear. You are assuming that increasing the supply of credit will mean an increase in the demand for money (real balances). It doesn't. An excess supply of money will get spent not held and will only become held after prices rise, and we get all the problems Austrians discuss.

What CAN happen is that if the public really wishes to restrict its current consumption by keeping larger holdings of bank liabilities, the banks can then turn those funds into loans to investors. That's what should happen, as the public's increased saving supplies the means to increase the capital stock through the intermediation process and the actions of the borrowers.

I think Nikolaj is confused about what is meant by the demand for money.


You state, "increase in demand for money is not the same thing as increase in saving. If it would be so, then you could increase capital stock indefinitely by simply increasing supply of credit."

This statement is incorrect and I am puzzled as to how you could make this claim. Those of us who believe that an incease in the demand for money is saving would strongly deny that the capital stock can be increased "simply" by increasing the supply of credit.

The demand for money is how money an individual wants to hold. The market demand for money is the sum of the individual demands for money.

It is possible for there to be an increase in the demand for money and a decrease in the demand to hold other sorts of assets. This is not an increase in saving, but rather a change in how individuals choose to hold wealth. If the banking system increases the quantity of money to match the added demand to hold money in that situation, then there is a decrease in direct lending (bond holding) and an increase in bank lending. There is no added saving, but neither is their an additional increase in the demand for capital goods.

If, on the other hand, there is a decrease in consumption spending and an increase in the demand to hold money, then this is an increase in saving. The decrease in consumption frees up resources to produce something else. If the banking system supplies more money, and increases the supply of credit, then the resources additional resources that are no longer used to produce consumer goods can be used to produce capital goods.

If, on the other hand, the quantity of money is increased, along with the supply of credit, and the demand for money has not increased, then the excess supply of money may will be used to increase the quantity of capital goods without saving. There might be a misallocation of resources. (Personally, I think that it takes a lot of assumpitons about interest elasticities to asset that capital production expands.)

Anyway, the notion that the capital stock can be increased indefinitely if an increase in the demand for money is saving, is false. Perhaps there is come difference in understanding about increases in real vs. nominal demand for money? (Generally, we are talking about both.)

Also, I have a favor to ask. Can you explain exactly how the economy returns to equilibrium when there is an increase in the demand for money. Please start with the economy in equiilibrium rather than talk about recovery from a "secondary" recession.

People choose to hold more money.. and...

Dear Bill,

Surely the answer to your question would run along the type of lines discussed in broad outline by John Stuart Mill in his "Unsettled Questions in Political Economy" (1844), in the essay, 'Of the Influence of Consumption on Production,' when he wished to defend "Say's Law" in the context of an increased demand to hold money.

Mill argued that as long as there are ends or wants that have not yet been satisfied there is more work to be done.As long as producers adjust their supplies to reflect the actual demand for the particular goods that consumers wish to purchase, and as long as they price their supplies at prices consumers are willing to pay, there need be no unemployment of resources or labor. Thus, there can never be an excess supply of all things relative to the total demand for all things.

But Mill admits that there may be times when individuals, for various reasons, may choose to “hoard,” or leave unspent in their cash holding, a greater proportion of their money income than is their usual practice.

In this case, Mill argued, what is “called a general superabundance” of all goods is in reality “a superabundance of all commodities relative to money.” In other words, if we accept that money, too, is a commodity like all other goods on the market for which there is a supply and demand, then there can appear a situation in which the demand to hold money increases relative to the demand for all the other things that money could buy. This means that all other goods are now in relative oversupply in comparison to that greater demand to hold money.

To bring those other goods offered on the market into balance with the lower demands for them (i.e., given that increased demand to hold money and the decreased demand for other things), the prices of many of those other goods may have to decrease. Prices in general, in other words, must go down, until that point at which all the supplies of goods and labor services people wish to sell find buyers willing to purchase them.

Sufficient flexibility and adjustability in prices to the actual demands for things on the market always assure that all those willing to sell and desiring to be em¬ployed can find work.

Surely this is also a part of W. H. Hutt's argument in "A Reconsideration of Say's Law." Every lowering of prices or wages more to their market-clearly levels increases the quantity demanded for their goods or labor services, enabling those sellers and workers to experience a greater revenue to demand more of goods that others are offering for sale.

This process moves the economy back towards that hypothetical equilibrium that, of course, in a changing world the market never reaches.

Richard Ebeling


I am not confused concerning what is meant by demand for money, but the very category of demand for money, as used by FB as justification for credit inflation is confusing. Demand for money is neoclassical macroeconomic artifact, just like aggregate demand, investment spending, general price level and so on. It has no praxeological significance, because one hardly can distinguish between exogenous and endogenous increase. Further, in the free market there is little reason to believe that there would be many sudden increases in demand for money. Most of those increases today are consequences of previous credit expansion. Supply of fiduciary media creates its own demand. So, demand for money is completely useless as analytical category which should provide to central banker or anyone else a guide how to rectify business cycle according to Austrian understanding of its causes. You are simply taking for granted that increases in demand for money today are endogenous, while we have every reason to believe the opposite.

In the FRB framework we have no way of distinguishing between the saving and creating money out of thin air. If every nominal increase in bank liabilities is automatically increase in saving, as you seem to suggest, then there was no boom at all. Market and natural interest rates were identical from the outset, including 2001-2004 in USA. All investment made in roundabout projects were appropriate and not creating artificial lengthening of production structure. Only if we treat the money as a commodity like any other commodity, which includes possibility to fluctuate both upward and downward in its price in terms of other goods, we can reasonably talk about its demand and supply as analytically useful categories. When money is not a commodity, you can create it out of thin air, and as Hayek rightly said that in such a sytem "nobody knows what is quantity of money".

Nikolaj once again puts words in my mouth that utterly distort my position:

"If every nominal increase in bank liabilities is automatically increase in saving, as you seem to suggest, then there was no boom at all."

I said NO SUCH THING at all. What I said was that an increase in the public's *desire to hold bank liabilities* is a form of saving as they reduce their consumption to increase their holdings. I also said that such an increase should be matched by the bank producing more funds for investment in the form of new loans and more bank liabilities.

Isn't this what we've known since at least Wicksell is the way to avoid a breakdown between the natural and market rates?

Once again, Nikolaj, I'm going to ask you to please do a better job at reading what I've written and not attribute to me positions that are diametrically opposite from what I hold. If I really thought that EVERY nominal increase in bank liabilities was a form of saving, why would I have been writing about Austrian cycle theory and inflation for 20 years, including its application to the current recession?

If I really believed what you say I do, then my two books and dozens of published journal articles would be difficult to make sense of, wouldn't they?

And if you think the demand for money has no place in praxeology, you'll have to explain pages 401-05 of Human Action, where Mises has an extended discussion of the demand for money, including this:

"With money, things are not different from what they are with regard to all other goods and services. the demand for money is determined by the conduct of people intent upon acquiring it for their cash holding." (404)

In fact, you should read that whole section as Mises really does say exactly the things I've been saying here about desired and actual money balances etc.. All sounds very praxeological to me.

But Steve,

In the section of Human Action you directed me to Mises talks about money exactly in the praxeological sense, as scarce commodity. He places it in only context in which we can distinguish between real saving and creating confetti out of thin air. And consequently to have praxeological notions of demand for of supply of money. What was precisely my point you protested. When we reject money as real scarce good, commodity (by accepting fiduciary media), we can speak about supply of and demand for money only in a very ambiguous, metaphorical way.

You are just flat out wrong Nikolaj. The concept of fiduciary media does NOT imply that money is not a scarce good. Under free banking with fractional reserves, money cannot be created without cost. It remains a scarce good and thus subject to all of the praxeological analysis in that section of Mises.

Second, nowhere in that section does Mises say anything that would suggest his analysis does not apply to fiduciary media. He defines money as a "medium of exchange" and says everything there applies to money as such. Fiduciary media ARE media of exchange, hence it all applies.

And you might also consider this on p. 430: "It is possible to specify the advantages which people expect from keeping a definite amount of cash. But it is a delusion to assume that an analysis of these motives could provide us with a theory of the determination of purchasing power which could do without the notions of cash holding and demand for and supply of money."

Again, here too, no matter the type of money, Mises is clear to say that we can't understand the value of of money without the idea of the demand for money.

This whole last back and forth makes me realize how much damage supposed "Misesians" do to Mises when they refuse to acknowledge that he did not invent a system of thought whole cloth out of thin air, but was, in fact, steeped in the theories, language, and methods of the great economists. Every time someone says "but that's not praxeologically valid," I should more frequently interpret that to say mean that they have little clue what Mises really said and that their understanding of his views is second or third-hand, or acquired via the views of later interpreters, and therefore just as likely to be wrong as right. The invocation of "praxeology" is too often a way to try to shut up the other party by seeming to have superior insight into Mises's thought. Of course, it only "seems" that way much of the time.

Mises was a hell of a lot better economist than most of the people who call themselves Misesians and he deserved a lot better fate than to have people do damage to what a great economist he was by trying to portray him as standing outside the very history he was deeply a part of.


Although we usually price goods in money, we can also price money in goods, and there can be a shortage of money no different, in principle, than a shortage of gasoline, bananas, or books.

If there is a general increase in demand for money, then the price of money in goods should increase, but prices do not adjust immediately, and for some time the price of money in goods could be too low. A shortage would follow until the price of money in goods increases, (thereby increasing the purchasing power of money). However, when faced with a shortage, price increases are usually a short-term fix. In the long-term we expect to also see an increase in supply. This is economics 101. (Think of the free-market arguments against "price-gouging" legislation).

Austrians seem to only like one kind of a response to a shortage of money, that is, an increase in its price. But what makes money special? Why shouldn't the market be able to respond to a shortage of money just as it would anything else? In other words, when there is a shortage of bank liabilities, why can't banks increase supply?

I don't understand why you want special rules for money, when you want no such rules for anything else. Why shouldn't we let the market work?

Lee Kelly:"Although we usually price goods in money, we can also price money in goods, and there can be a shortage of money no different, in principle, than a shortage of gasoline, bananas, or books."

Yes, in monetarist or Keynesian theory. In classical economy and Austrian theory, every quantity of money is optimal. When demand for bananas increase, their price increases, and people must pay more money for the same quantity of bananas. When price of money in terms of goods increase, monetary value of goods must decline, just like in previous case. Austrian free bankers, drawing inspiration from old Bank School's doctrine of "needs of trade" complain that such a situation is somehow disruptive and must be rectified by new bank credit to stabilize prices, i.e. preclude "dangerous deflation". But, this is directly opposite to ABCT that says that malinvestment induced by expansion in bank credit must be liquidated, not given additional fuel by new credit inflation.

So, "shortage" of money is pretty senseless concept. It is just expression of personal opinion, and maybe polemic figure for those who want more inflation, not some analytically clear notion.

"In other words, when there is a shortage of bank liabilities, why can't banks increase supply?"

Money is a commodity used as a medium of exchange. Fiduciary media created out of thin air IS NOT money in a sense which allows you to analytically clear talk about its supply and demand. So banks can create additional credit without changing of social rate of time preference, but cannot at the same time claim that has anything to do with stabilization of economy. At least from the perspective of ABCT.

Even Hayek, who was not ardent supporter of 100% reserve standard (although he advocated it in some of his writings) said in FRB system nobody can know what is the money supply, and that such kind of system nobody "can't control". There is no market for money, because money is not commodity that is freely traded and valued against other goods, because we have market agents, called FR banks that are legally allowed to counterfeit money by issuing fiduciary media. There is no free market in money, so we cannot let it work.

"If there is a general increase in demand for money, then the price of money in goods should increase, but prices do not adjust immediately, and for some time the price of money in goods could be too low."

Again arbitrary personal impressions dressed as scientific statement. "Too low"? Compared with what standard? If you know what is the right price of money in terms of goods, then you are God, or at least omniscient central planner.:) You don't need any sort of market at all in that case. But, af you are not any of the previous two guys, then please stop pretending you know that some particular price is "too low".

" Austrian free bankers, drawing inspiration from old Bank School's doctrine of "needs of trade" "

Uh, no, we explicitly reject any "needs of trade" or Real Bills Doctrine. You'd know that if you'd actually read White or Selgin.

"complain that such a situation is somehow disruptive and must be rectified by new bank credit to stabilize prices, i.e. preclude "dangerous deflation"."

And here we side with Wicksell as well as a whole line of classical theorists of the pre-Keynesian era. Plus, we're not interested in "stabilizing prices" per se. We're interested in keeping the market and natural rates synchronized. If there is no response to an increase in the demand to hold bank liabilities, the market rate will be above the natural rate, and that's problematic. I note you've yet to respond to this argument.

"But, this is directly opposite to ABCT that says that malinvestment induced by expansion in bank credit must be liquidated, not given additional fuel by new credit inflation."

You keep calling it "credit inflation" but that begs the question. The whole argument is whether such increases in the supply of money to match the increase in demand are, in fact, "credit inflation." You keep asserting that they are, without argument. The ME-FB argument is that they are not.

Austrians, really Wicksellians including Mises and Hayek, have always insisted that the key to macroeconomic policy is making sure that the natural and market rates of interest are in sync with each other so as to avoid intertemporal discoordination. The prescription of expanding the money supply to match an increase in money demand is designed to achieve that Wicksellian goal, just as Austrians have long argued that we should avoid inflation so that we achieve that goal as well. All I'm arguing is that, as George Selgin said in an earlier thread, that we be consistent about avoiding intertemporal discoordination on both the excess money supply and deficient money supply/excess money demand sides.

If, as an Austrian, you're concerned about the market rate being below the natural rate, you should also be concerned when it's above the natural rate.


It seems to me that many self-described Austrians are solely concerned when market rates falls below the natural rate, but not when market rise above the natural rate. Moreover, while we ordinarily expect market to resolve shortages with both price and supply increases, the same Austrians make an exception for money (i.e. bank liabilities), and oppose any change in supply.

Why do you think this is? You suggest that it is not from Hayek or Mises these ideas are derived, so where has it come from?


When trying to communicate about complex topics like monetary policy on a blog format, I think some generosity when interpreting the comments of others is appropriate. In other words, if something I write seems really stupid, then try reading it again, and if there seems to be more than one possible interpretation, I mean whichever one is less stupid.

When I wrote "the price of money in goods could be too low" what did I mean? I assure you it was nothing that ought to be controversial. You prescribe allowing the deflation of a secondary recession to occur, but a deflation occurs gradually, not instantaneously, as market participants seek out the new equilibrium price. It is while this process is ongoing that the price of money in terms of goods is too low, i.e. lower than the new equilibrium.

If it were not the case that the price of money in terms of goods could be too low, then there would never be any deflation at all.


I think it comes from the Rothbardian interpretation of Mises. When I was a pup, I was a 100% reserve guy and would have never believed the arguments my current self is making. I got that set of views from reading Rothbard, esp. MES but certainly his stuff on the Fed and the first chapter of AGD as well. The Rothbard version of Mises is not utterly implausible. I think you can find some textual support for it, though not as much as you can for the monetary equilibrium reading.

In the earlier thread on monetary fatal conceit, Nicolas Cachanosky posted a link to a paper of his in this comment:

I read that paper a few months ago and it is an excellent close reading of Mises with plenty of textual evidence that argues against the Rothbard-DeSoto 100% reserve reading of Mises. It's well worth people's time.

In any case, for a few decades, Rothbard's version of Austrian monetary theory and policy was the only game in town and many of use who came to AE in the 70s and early 80s took those views. It was not really until Larry White's *Free Banking in Britain* in 1984 that there was an alternative, both theoretically and institutionally, to the Rothbard interpretation of Mises.

For those who still come to AE through Rothbard's (and now Hulsmann and DeSoto and others, who write in that tradition) work, the ME-FB framework is foreign. When you add on top of this the claim by the Rothbardians that fractional reserve banking is not just inherently inflationary but fraudulent and therefore immoral in a libertarian world, it's not a surprise you get people who are very resistant to the sorts of arguments I've been raising.

I also think that there's a real difference between the views of producers of AE and consumers of AE on these issues. The percentage of PhDs who do AE who are ME-FB types, or at least reject 100% reserves, is much higher than the percentage of blog commenters/interested and fairly well-read laypeople/academics in other disciplines who follow AE who buy the ME-FB story.

At the risk of sounding like Pete (and I largely agree with him on this issue), I do think there's something to be said for the deep engagement with texts outside the Austrian tradition and with other smart people that comes from graduate school, especially at really good programs. Perhaps there's a reason why most (though not all) of the folks who have gone that route are much more skeptical of the Rothbardian story than are those who haven't.

Pete: I think you confuse my claiming that, as a matter of theory, it is desirable that MV be stable, with the claim that we can trust central banks to achieve this outcome or the claim that they are perfectly capable of achieving it.

In fact, as you well know, I don't believe that central banks can be relied upon for the purpose of macroeconomic stabilization.

So if someone insists (as Rothbardians on this blog tend to do) it's just dandy to let MV collapse, and I feel obliged to reply that that isn't so, my saying so doesn't imply that I'm embracing discretionary monetary policy. On the contrary: to assume that it does is to assume that a desirable pattern of money supply adjustments cannot be achieved, even approximately, by free market institutions.

I hope that answers your question.

"When trying to communicate about complex topics like monetary policy on a blog format, I think some generosity when interpreting the comments of others is appropriate. "

I was about to say the same thing to the rest of you. You've been ganging up on Nikolaj and telling him he's "flat out wrong" and so forth, but I think he has asked some good questions.

From what I can tell, his underlying theme is that Austrians should be careful about interpreting inflations, deflations, and perceived demand for money, and proposing monetary policy as a fix, because they themselves are the results of monetary policy.

Austrians, better than anyone, know that demand is subjective and is influenced by uncertainty and by prices which in this case were fixed centrally. Monetary policy is not my thing, so I will stop there - just wanted to say that I think you guys should take his questions more seriously.

"There is no market for money, because money is not commodity that is freely traded and valued against other goods."

Honestly I couldn't decide which of Nikolaj's many wrongheaded assertions to choose to indicate his week grasp of monetary economics. But this seems like as good an example as any.


Thank you for your extended quote from Mill.

This is, of course, the monetary disquilibrium view.

So, let us be clear about some things. You are preaching to the choir if you are trying to explain that a lower price level will result in a return to equilibrium.

This is the conventional view, though I admit that I find it troubling when I read new Keynesiasn, who had seemed to accept this view, reverting to various "special cases" where it supposedly wouldn't work out-- a la Keynes.

But still, new classical economists believe this process works pretty much instantly. Orthodox monetarists believe (believed) that the process would work out eventually. New Keynesians appeard to accept the old monetarist view on that account.

It was the post-Keynesians would continued to deny the process would work out.

Oh, and of course, this is the core idea of the monetary disquilibrium theorists--Yeager, of course. And Selgin, White, Horwitz, and Garrison all pretty much agree with Yeager on this front.

The Rothbardians come closest to the new classical economists in arguing that this process not only works, but works pretty much instantly.

The actual classical economists generally understood that the process worked slowly and painfully. And Yeager is a good source for late nineteenth century and early twentieth century economists who understood this.

A shortage of money is a situation that leads to a lower price level, exactly like Mill described.

A shortage of money isn't a situation that leads too.. what? Permanent unemployment equilibrium? Lines at money stores? What can you possibly be imagining we have in mind?

This is what the rest of us mean when explaining that the real quantity of money rises to meet the demand. It is the process through which this actually occurs that involves surpluses of goods and services in general. Restricted levels of production (in response the the surpluses.) Lower levels of employment (due to layoffs are reduced hiring) because of the reduced production.

And, it is this situation that can be described (and I do describe) as reduced aggregate demand, real income and output below potential, and the unemployment rate above the natural unemployment rate.

And all the surpluses of various good and surpluses result in downward pressure on prices and wages. When the price level has fallen enough so that the real quantity of money matches up with the demand for money, then we are in equilibrium.

It isn't the usual story of lower demand, leading to lower relative prices, and a shift of production from one product to another. It is impossible for the prices of everything to fall relative to everything else.

It is this special situation where the purchasing power of money rises to meet the demand to hold it. Mises explains it so well.

The notion that we cannot measure the demand for money effectively (or the natural interest rate, or potential income, or the natural rate of unemployment) doesn't make these concepts useless. They are tools to understand a specific set of phenomena. Just like basic supply and demand help us understand the shifts of production between different goods in response to consumer values and opportunity costs. Just like the concept of relative prices help us understand that exchange ratios are impacted on the market.

Anyway, no one disagrees that adjusting the nominal quantity of money to accomodate increases in the demand to hold money isn't fraught with difficulty. That people will accept money in payment with the intention of spending it rather than holding it does create problems. On the other side of the coin, the ability of people to accumulate money without going to a market and buying it, by simply reducing spending out of current income creates problems. It is the nature of money.

However, strawman arguments do you no good. No one is arguing that the nominal quantity of money should rise _because_ the increase in the demand to hold money is irrational. (Wouldn't that be an odd notion. Does that imply that if the increase in the demand for money were rational, the nominal quantity of money should remain the same?) No one is claiming that increasing the quantity of money in order to make new loans allows increases in the production of capital goods without limit.

To me, the fundamental principle of all economics (micro and macro) is scarcity.

I can assure you that my understanding of monetary eqilibrium and disequilibrium is consistent with scarcity.

How much more seriously am I supposed to take his questions Liberty? I've attempted to answer every single one of them. Yes, I've been sharp at times, but let's remember: he's been throwing all kinds of ad hominem arguments at me from the start. My sharpness is simply tit for tat. If I really thought his questions were so unserious, I would have ignored him long ago.

I'm not about to start feeling guilty for spending several hours of my time responding to someone who thinks I'm an inflationist/central planner/constructivist etc. etc.. I perhaps should feel SILLY for responding, but I'm not going to be made to feel guilty for not taking him seriously when I've probably taken him far more seriously than I should have!


regrettably, you are completely wrong in ascribing to Mises theory that money in praxeological sense includes fiduciary media. In the section of Human Action we are talking about he says:

"A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production. Money is a medium of exchange. It is the most marketable good which people acquire because they want to offer it in later acts of interpersonal exchange. Money is the thing which serves as the generally accepted and commonly used medium of exchange."

So, he is speaking about money as "most marketable good" and "good that people keep for exchanging it at later date" and so on. It seems like he refers to gold here, and not on IOU, doesn't he?

Further, it is ironical that you object to me some cultist relationship to Mises. It was you who had been trying to find textual support in Holly Script at least 7-8 times in last 3 days for your views, even if there was not such support (like in this previous case, or in the case in free banking, where it was also very weak). I think you are little oversensitive, and you see Alabama Talibans everywhere, who want to haunt you down and deny your Austrian credentials.

As for praxeology, your aversion towards the word is natural, because your methodology and your style of thinking is macroeconomic and neoclassical, which is to say holistic. You are concerned with price level, average velocity of money, demand for money, general price level. You don't bother yourself to concentrate of individual interactions that give rise to individual changes in prices, but with macroeconomic aggregates. "Praxeology", on the other hand, is the second name for methodological individualism, for style of theorizing that tries to explain social phenomena by reducing them on individual human action. This is the reason why you always cite PQ=MV, and say that "stabilizing MV is optimal monetary policy during recession", while I am asking what does it mean to assume that millions of people who behave rationally, holding more cash as insurance from uncertainty during recession, pose a macroeconomic problem of "dangerous deflation". And why deflation is a "problem" of economic policy any more than drop in prices of wheat or corn?

And, to emulate your approach these days, and with additional risk of being labeled as Alabama Taliban I must cite another paragraph from Mises which nicely spells out these previously discussed features of your style of thinking:

"In analyzing the equation of exchange one assumes that one of its elements—total supply of money, volume of trade, velocity of circulation—
changes, without asking how such changes occur. It is not recognized that changes in these magnitudes do not emerge in the Volkswirtschaft as such, but in the individual actors’ conditions, and that it is the interplay of the
reactions of these actors that results in alterations of the price structure. The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion
of velocity of circulation fashioned according to the patterns of mechanics."


I don't want to get into a discussion about the discussion, but I do want to comment for clarification.

"When trying to communicate about complex topics like monetary policy on a blog format, I think some generosity when interpreting the comments of others is appropriate."

When I wrote the above, I did so to remind myself as much as Nikolaj, because throughout this discussion I feel as I do when arguing with so many progressives. In such discussions, If I should suggest a free market solution to whatever problem is being discussed, then I sometimes receive a response along the line of, "oh, so you support the war in Iraq". Hayek wrote an entire essay called "Why I Am Not a Conservative", and after arguing with Nikolaj, I almost feel like writing an essay called "Why I Am Not a Keynesian".

It seems as though Nikolaj has a stock of arguments which he employs when discussing monetary policy, but these arguments only work against that set of ideas which are commonly referred to as "Keynesian". (I have never read Keynes's work, and probably never will, but it seems to me that modern Keynesian economics may have less to do with Keynes than many of its proponents suspect). But what Steve Horwitz, George Selgin, myself, and others are arguing is not Keynesian, even though it may have some superficial similarities. I feel as though Nikolaj is trying to force me into a position against which his prearranged arguments will work, and not seriously considering that I might have something interesting and useful to say. Of course, I might be wrong, but that is what it feels like.

"From what I can tell, his underlying theme is that Austrians should be careful about interpreting inflations, deflations, and perceived demand for money, and proposing monetary policy as a fix, because they themselves are the results of monetary policy" - Liberty

I think all of us who have argued against Nikolaj have expressed the same concerns.

Nikolaj writes:

"So, he is speaking about money as "most marketable good" and "good that people keep for exchanging it at later date" and so on. It seems like he refers to gold here, and not on IOU, doesn't he?"

No, it doesn't. "The most marketable good" is a fairly standard Mengerian definition of money and can refer just as well to fiduciary media or fiat money as to gold. Are Federal Reserve Notes not the most marketable good in the US economy? Yes they are. This is just another way of saying they are money. Everything Mises says in that paragraph you and I quoted applies to many more things than gold. The fact that you have to say "It seems like..." when Mises says nothing like what you want him to say is what gives the game away.

I didn't say you had a cultish relationship to Mises. You might, you might not. I cited Mises and explicitly said you can find in Mises support for both of our views. That's hardly cultish. You are the one who keeps insisting that Mises's text supports only your view. I'll lead the readers decide which, if either, sounds more cultish.

As for denying my Austrian credentials: is that not what you've been trying to do this whole discussion? I have no doubt about my credentials along those lines. I just wish people like you would stop trying to monopolize the term for your particular Rothbardian reading of Mises.

And as for praxeology... I don't object to the term. I've written papers about it, praising it even. I just object when it gets used as a substitute for an actual argument, which is often how it is tossed about. To say "that's not praxeologically valid" is to employ some sort of "shut up" rather than an explanation of why the particular thing doesn't make sense as a way to do economics.

Your discussion of MV=PY that follows is a perfect example. Everyone knows the limitations of that approach, but sometimes it's a convenient shorthand to express the underlying ideas. I wrote a whole big book called "Microfoundations and Macroeconomics: An Austrian Perspective". You might have heard of it; you might want to read it. In that book, I articulate how Austrian macro rests on Austrian micro and how any good analysis of macro phenomena must be linked back to micro and to, surprise!, methodological individualism. So your attempt to portray me as denying the importance of such things runs into several hundred pages of text to the contrary.

It really would help the conversation here if you'd read my book. Since we're talking about the core ideas there, you might have a more accurate understanding of my views.

Finally, the phrase "Alabama Taliban" is yours, not mine, so please stop making it seem like it's something I'm using or part of my argument. I have never used that phrase in this conversation or any other, and I find the term itself offensive, which is why I wouldn't use it, and I find it even more offensive that you would try to put it in my mouth.


Have you ever looked closely at a large posters? Usually, their images are comprised of many small dots in only three colours. It is from the relative to mix of these coloured dots that the perception of other colours emerges at a distance.

It can be true to say that a poster is purple, even though, upon closer inspection, it contains no purple coloured dots. In other words, true statements can be made about macro properties of a poster, without denying anything micro. I think very much the same thing can be said of the economy, and it does not condemn us to Keynesianism. The level of analysis we choose when addressing problems depends on the specifics of problem.

The standard Austrian critique of the Keynesian story of the business cycle is that concepts like "aggregate demand" obscure important variables. In other words, while true statements can be made about aggregate demand, and it may be a perfectly useful concept in come circumstances, it operates at the wrong level of analysis to understand the business cycle.

There is nothing non-Austrian about recognising that sometimes macro properties are sufficient to discuss a problem. If that is non-Austrian, then I am certainly no Austrian, and neither would I desire to be.

I just responded to someone at the Think Markets blog about this issue, where it was said that credit expansion robs savers of the value of their savings.

It seems to me that the primary insight of proponents of free banking is that credit expansion is sometimes necessary to *preserve* the value of savings. If the market rate of interest rises above natural rate, then it has the opposite effect of artificial suppression by a central bank. Instead of people getting credit that shouldn't, people that should get credit don't. A general shortage of money (at the prevailing prices) will then render many saved resources unemployed. But when saved resources are unemployed, they go to waste and depreciate the value of savings.

It is as though we held our savings in fruit. Since fruit spoils quickly, any savings in fruit rapidly depreciates. But if you invested your fruit in someone else, so that in the future they could pay you back with fresh fruit, then your savings are preserved. This is what credit expansion during a secondary recession can achieve.

By the way, Steve and George, I am still trying to figure this stuff out, so if any of this is wildly off base, feel free to tell me.


I really think that the key problem created by monetary disequilibrium is that it interferes with the exchange of labor for consumer goods. It isn't primarily about savings being wasted.

Also, keep in mind that in a growing economy, credit should be expected to expand. Most credit is not funded by the issue of money. Ultimate lenders hold other sorts of financial instruments. Banks don't provide the majority of credit and banks fund a substantial fraction of credit with C.D.s (In my opinion, a substantial portion of savings accounts are not the medium of exchange either.)

Sometimes I get the impression (perhaps falsely) that "popular" Austrian economics sees all credit as an inverted pyramid built upon a tiny foundation of base money. I think that this approach fails to see that credit is mostly about shifting funds between and among households and firms. The stocks of outstanding debt and the wealth of those holding the debt is built up out of those flows.

Because most money is used to fund loans, and people accept money both when they want to hold more money and when they want to spend the money, there can be an imbalance between the quantity of money and the demand to hold it without showing up as a surplus with frustrated money sellers. The money producers (the banks) can get rid of it because people take it, intending to spend it. But it is that space between the amount poeple want to hold and the amount that has been created that results in an excess supply of credit, which is cleared by lower interest rates. Once prices rise, and reduce the real quantity of money to the demand for money, then this increase in the real supply of credit disappears.

On the deflationary side, there can similarly be an imbalance between the amount of money people want to hold and the amount that exists. If this is "fiduciary media" that deviation involves less real credit than would otherwise be funded. But once the price level falls and brings the real quantity of money up to its demand, the real value of the credit has risen. The same nominal quantity of fiduciary media funds nominal loans that purchases more goods and services.

These disequilibriums aren't anything like all the credit in the economy. I somtimes wonder if the "fractional reserve banking as fraud" approach, combined with a lack of care in distinguishing between nominal and real quantities of credit don't greatly exaggerate the extent of "credit inflaion."

If the quantity of money falls back to base money, bank lending falls. And this should reduce the real supply of credit to some degree. There is no particular reason to think that the rest of the credit markets should shrink in real terms, but the deflation of prices means that they will shrink in in nominal terms. Of course, the reality is that all of this deflation would be associated with lots of bankruptcies too. But in some appropriately defined long term, the lower nominal amount of credit funded by nonmonetary credit instruments should have the same command over goods and services as the credit funded by these sources before. Prices are lower. The decrease the real quantity of credit in the long run would simply be a reflection of the larger fraction of wealth held in the form of real base money.

The question, I think, is whether to the degree people choose to save by holding money, it is best for the quantity of money to expand, and, at the same time, fund loans. I think the answer is yes.

As for your discussion no Think Markets, both of you need to consider the "Fisher effect." If both lender and borrower understand that an increase in the demand for money is going to result in deflation, then this will be reflected in the interest rate on the loan. The nominal interest rate should be lower. And so, the lender (saver) isn't gaining more purchasing power because of the deflation. If, instead, the quantity of money expands to meet the demand for money, so that this doesn't create deflation, then again, this will be reflected in the supply and demand for credit, and nominal interest rates will be higher. The lender (saver) will earn more. It is only if this is a surprise will the lender (saver) receive a windfall gain because of deflation.

By the way, what happens when the demand for money falls? If it is unexpected, then lenders (savers) will take a loss from the unexpected inflation.


I hate to sound all Marxisty, but to what degree is popular Austrian economics the ideological superstructure of an ideology whose goal is to maximize the wealth of gold investors? Consider both the analysis of actual market systems that are inevitibably heading to a disaster in which gold holdings will be the only source of wealth, and reform proposals that maximize the value of gold going into the new system.


I think that hypothesis has significant empirical support. It also explains a lot, doesn't it?


I am really confused and a bit dazed by Bill Woolsey's last comment. Hopefully he is not seriously asserting a conspiricy theory. If he indeed is, it would certainly be the silliest one I have heard yet.

Does anyone here think that the incredible fiscal policies that are currently being pursued (not only the US) will not eventually need to be monetized by either very high taxes or printing much more money? It does not take an academic economist to see that this path does not end well in any concievable scenario which one may dream up. Unless fiscal policy is drastically altered (which there does not seem to be much hope of now) there is eventually trouble ahead. That is no conspiricy theory or doom and gloom prophesy but just good plain reasonable thinking.

I am personally convinced by the Selgin/White/Horwitz FB/FR arguments and I am no Rothbardian, but the Woolsey comment is silly (maybe it was meant to be silly). I own some gold, and it does not stem from any association with the Mises Institute or believing in Jimmy Rogers or Peter Schiff. Let me humbly suggest that over the long run, it may not be unwise for you to own a little too.

I think Bill was perhaps overstating things a bit. But I do think that the interests of those who have what I would call an "overly strong" attraction to gold do seem to be a key piece of the support for 100% reserve banking. And yes, given the prospect for future inflation, owning gold is a good idea. But it's also not a religion.


Although I appreciate the response, your meandering style of writing defeats much of its purpose. It is difficult for me to disentangle the web of thoughts and determine how your response pertains to my comment. Perhaps you should quote the specific parts of text that you are responding to, and try to adopt some common terms.

In any case, I understand that not all investment spending is done via banks, but since we are discussing a secondary recession, for the sake of clarity and brevity, I wrote as though it did.

A secondary recession occurs because of a sudden increase in the demand for money, and banks become a more important source of investment spending. After a bust, in the ensuing confusion and fear, money becomes an attractive alternative to stocks, bonds, etc., and the market is flooded with sellers looking for liquidity. This is followed by a general shortage of money throughout the economy at the prevailing prices, setting in motion a prolonged and painful period of deflation.

In a 100% reserve system, banks would be like warehouses, and upon the onset of a secondary recession, would be unable to increase their lending in response to greater demand for their liabilities. Meanwhile, many of the resources being saved by holding money are going unemployed, and not being harnessed to produce future output for savers to buy. In other words, during a secondary recession, savings held in a 100% reserve bank are like rotting fruit, but with fractional reserve banking the real value of those savings can be preserved by increasing the supply of bank liabilities.

In other words, score one for fractional reserve banking. Does anyone here know who else has made this argument, if at all?


a couple questions have arisen to me:
1) your description of demand for money includes "bank liabilities" (demand deposits), and, if the demand rises, this, per your thoughts, involves a subsequent rise in "bank liabilities", which under free banking will be exchanged to business loans; but lets imagine an economy prior to the introduction of credit cards, where people keep their cash balances in currency and there are no demand deposits (only time or savings accounts). But suddenly credit cards are invented and all people in the economy put their cash balances in this - credit card - form. They do not change their spending habits: the only thing that changed is only that cash balances are kept as demand deposits. This subsequently means a huge increase in "bank liabilities", but no change in time preference. But since you state, that increases in "bank liabilities" should be accompanied by increases in business loans, then in this example I have given under free banking banks will expand huge amounts of credit, which will cause misalocations and malinvestments. Do you agree?
2) If we assume, that, indeed, extra money supply is needed to offset sudden huge increases in the demand for money, then the next step for causal analysis is to look upon what happens next, when that sudden increase in the demand for money goes back to the normal levels. My opinion is that, during this return to normal demand for money, new misalocations will occur, as the action involved will be similar to what happens during genuine inflation;
3) Further, I even contemplate, that the increased demand to hold money could send different signals, than that we need higher real cash balances. If in an economy a new technology is introduced, which pushes the PPF up a lot, and if then people decide to increase their demand to hold money, maybe this action ought to be as a signal that the scarcity problem has been solved, that is, people, by holding their money, tell that they dont need so much consumption and investment goods as the new PPF allows them to get. That it is why they want the PPF to go somewhere between the old and new levels, where they will agree with possible consumption and investment ratios. And only later maybe they will want to search for a new state with a smaller uneasiness level.

Very good article.

In my opinion, it is all a matter of market timing. It does not matter if it is gold, oil, or Microsoft, if you have access to good market timing signals, they will help you get in and out at a profit.

No guarantees in this business, but if they are right most of the time, you can still make $s.

There are may web sites providing them out there (search Google). Just find one that works and use it! Check out as an example.

Its Dow Jones timing signals are up 43% as of 6/23/09 while the Dow is up just 29% off its March lows.

Following a market timing system works!


Good questions. Gonna take them in order.

1. You've missed a key point here. Under free banking, currency IS a bank liability! In a free banking system, if the public suddenly shifts from currency to deposits, the only difference that makes to the banks is that they might be paying interest on deposits. It has NO other effect on the bank's balance sheet - it's just a switch in the form in which the public holds bank liabilities. This is one of the great strengths of free banking. A switch in the c/d ratio has no effect on the total supply of credit.

Of course in the current US system, the switch you describe would indeed be problematic because a move from holding FR notes to deposits would generate a multiplicative increase in the money supply (as it's a move from non-bank to bank money). The fact that central banking systems are vulnerable to shifts in the c/d ratio is one of their big problems. I discuss this issue in my SEJ article from 1990 here:

2. Does your argument assume that the free banks are unable to recognize the downward shift in the demand for money? If the demand for money falls, free banks have a reason to reduce their outstanding liabilities, as the reduction in the willingness to hold their money means that they are seeing reserves drain away at the clearinghouse or in their vaults. In either case, profit-seeking will lead them to reduce their liabilities in response. This is the same argument for why they won't inflate in the first place. You are right, however, that the consequences of the demand for money falling (given monetary equilibrium) are the same as the supply of money rising (given ME).

3. I must confess I don't follow your argument here. Perhaps another reader can clarify or you can restate it.


I found the "credit card" business from Darius confusing. Perhaps he meant "debit cards."

Anyway, I think the "problem" Darius is thinking about is the move from 100% reserve banking to fractional reserve banking. The change in equilibrium as the demand for base money falls. The banking system increases the quantity of monetary financial instruments as the demand for them rises. But since this is a substitution away from base money, what happens to the quantity of base money as the demand for it falls? If the quantity remains unchanged, then the price level rises (or the purchasing power of money falls) until the real quanity of base money falls to equal the new, lower real demand.

With a fiat system, my view is that the monetary authority should reduce the nominal quantity of base money as the demand for it falls. My view is that the "problem" is with base money. The banking system is supplying what the market demands. There was an innovation (the disovery of financial instruments that can be used for monetary purposes,) people find them useful, and the banks supply them. The only problem is that base money fails to adjust except through this indrect backwards way through changes in the prices of everything else, so that the real quantity adjusts to the demand.

Of course, if gold services as base money, and there is a reduction in the demand for gold because the market finds some way to provide monetary services with less gold, then destroying gold would hardly be sensible. Of course, the additional gold jewelry, dental work, and electronic circuitry, as well as the other goods that can be produced with resources otherwise devoted to mining would be the benefits of reduced use of gold for monetary purposes.

Darius appears focused on whether or not there is malinvestment generated as part of this process. That is, the process of a subsitution of various sorts of financial assets for gold.

Now, it is interesting to think about credit cards. While the line of credit (or unused portion thereof) of a credit card doesn't count as part of the quantity of money, it seems likely that credit cards reduce the demand to hold money. I know that I hold less money because I have a line (well, several lines) of credit. I think it is obvious that this reduces the demand for money, including base money. It a 100% gold standard world, this would result in a higher price level and reduced purchasing power of money, so that the real quantity of money falls to meet the lower demand.

Does it create malinvestments? Again, this is the adjustment process due to the reduced demand for base money. Surely, Mises covers this because it is no different than trade credit. Shopkeeper Smith lets his customers at the General Store run a tab, which they settle up when the get some money. That sort of activity reduced the demand for money.

Is offering a line of credit fraud if one doesn't store sufficient money at all times to make the promised loans?

Scott Sumner asked me an interesting question about this on his blog.

How can banks distinguish the different demands for money? There is the demand for money to buy capital, the demand for money to buy goods and services and the demand for money to hold.

Is doing so actually necessary?

Steve, does your Free banking theory put capital goods such as shares on an equal footing with other goods?

In his article "How would the Invisible Hand handle money" Selgin uses T to represent all transactions. Then he uses MV=PT.

"Monetary Equilibrium" folks such as Sumner use MV=PQ but have the PQ equal nominal GDP. This is really something completely different.

Current: Demand for money is demand to hold money, not to spend it on this or that. (When money is spent, the demand for it falls, while the demand for the stuff it's being spent on rises.) This distinction between the demand for money balances to hold on to (genuine demand for money) and the demand for money for immediate spending (pseudo demand) is a crucial aspect of monetary economics.

The problem you raise in your last post is thus a pseudo problem. Banks don't have to "know" what money is demanded for. They just need to provide for increased holdings of the stuff that would otherwise subtract from the flow of payments. And what's more, under free banking, the banks don't even have to "know" how much money people wish to hold: they aren't central planners; they are guided by profit signals. It's only central bankers who cannot hope to do their job without somehow "knowing" the extent of money demand.

And yes, White and I refer to MV = PT instead of MV = Py (implying a different measure of velocity). But if you read our argument carefully, it includes a parameter representing the relationship between PT and Py.


It seems to me just as though Scott Sumner issued Scott Dollars which could be redeemed for economics lessons. Let's suppose Scott can only give about 2 economics lessons a day. If so, then how many Scott Dollars he spends will depend on others' demand to hold them.

Suppose, at first, that he spends and average of 2 Scott Dollars per day, and redeems the same amount. Later, the demand to hold Scott Dollars increases and he discovers that only 1 is redeemed each day. Scott can then double his spending of Scott Dollars (i.e. increase supply), and still only redeem 2 per day. Likewise, if demand declines then he can just reduce his expenditures.

The point is, Scott needs nothing but ordinary market feedback to calibrate how many Scott Dollars he supplies to the economy.

George Selgin: "And yes, White and I refer to MV = PT instead of MV = Py (implying a different measure of velocity). But if you read our argument carefully, it includes a parameter representing the relationship between PT and Py."

On page 23 of "Bank Deregulation and the Monetary Order" you show that if:

Income = Transactions * a constant
Transaction velocity = Income velocity * a constant

then MV = PQ = NGDP is stabilised.

But the constants need not really be constants do they?

George Selgin: "Demand for money is demand to hold money, not to spend it on this or that. (When money is spent, the demand for it falls, while the demand for the stuff it's being spent on rises.) This distinction between the demand for money balances to hold on to (genuine demand for money) and the demand for money for immediate spending (pseudo demand) is a crucial aspect of monetary economics."

I agree with you mostly here and I think this is the really important point. Which is why I asked Scott Sumner why he wishes to take out the capital goods and differentiate between these different demands.

In a hypothetical barter economy people may decide to buy fewer new goods and services and more existing capital goods. This sort of thing lies outside of monetary economics.

As for the title of Pete's post "What monetary policy can do", and repeated assertions of many free-bankers that Hayek's prescription for monetary policy during depression is to stabilize MV, I must note that this interepratation is flat-out wrong.

Larry White cites in discussion with De Long following Statment from "Prices and Production" as a smoking gun evidence that Hayek was actually a Whiteian-Selginian:

"But I think that what I have already said on this point will be sufficient to justify the conclusion that changes in the demand for money caused by changes in the proportion between the total flow of goods to that part of it which is effected by money, or, as we may tentatively call that proportion, of the co-efficient of money transactions, should be justified by changes in the volume of money if money is to remain neutral towards the price system and the structure of production."

But, White only fails to cite the very next paragraph where Hayek says:

"in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy."

So, stabilizing MV for Hayek was only theoretical possibility, while he decisively rejected it as a policy prescription. He understood very well practical impossibility of determining who needs a money, without causing another round of misdirection of capital and credit cycle inflationist episode.

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