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But, Steve, is it not the case that what you and some others here want (not sure about Pete B.) is free banking? Why are you not calling for a move to that in the crisis rather than getting all worked up about one sort of more trivial intervention than another?

BTW, and there is that odd technicality that the Fed is actually privately owned, even if it was set up by the government. But then any move to free banking would be, "set up by the government," and I am sure there would be some sort of regulatory or legal apparatus that would go along with it.

As I said over at MR Barkley, yes I'd prefer free banking. And I've called for such a move in that direction in several publications/talks in the last year. But that was not on the table last fall as a serious policy option and libertarians can have discussions, like the one Tyler initiated, about what's the best option in the world of the second best. That's all this is in my view: from a libertarian perspective what was the best, or least bad, decision last fall, given the realistic options on the table. Frankly, that's a much more interesting discussion *among* libertarians than us all nodding about free banking or debating fractional reserves vs. 100% reserves for the 40 millionth, and each progressively more annoying, time.

Steve,

Tyler is a brilliant debater, but his point isn't just a debate point, it is also a subtle point once you depart from line-in-the-sand libertarianism. My problem has always been (and you can see this in Why Perestroika Failed next to last chapter where I attempt to engage in political theory) that I seek to develop a rule utilitarian argument that dovetails with the moral philosopic principles of self-ownership and non-aggression and can be instituted through constitutional design (Hume-Hayek meet Locke-Nozick and get together via Hobbes-Buchanan). In other words, the bright lines are drawn, but not by reference to rights theory, and they are instituted through soclal contract. Perhaps the exercise is only wishful thinking on my part and doesn't work, but it is how I reconcile positions in my mind.

But Tyler is making a Warren Samuels type point about government and the market. The bright line drawing is an act of intervention in this way of thinking.

So the bottom line is that Tyler is pushing us to say that IF there was no bailout (put aside for the moment the technical question of monetary policy independent of the bailout), then the normal process of bankruptcy through our current court system would have demanded an increase (as you right point out) in the scale of government no less dramatic than what we have seen. I agree with your distinction between scale and scope, and that the real issue is scope (I've gotten mocked at on more than one ocassion by my studentes such as Ed Stringham and Pete Leeson for my insistence that it is scope and not scale that is the real problem of government). But Tyler's concerns are also why several of the proposals on how via bankruptcy market correction could have coped with the crisis call for stripped down procedures.

So not only is Tyler claiming that if we would have gone in the more "liquidationist" direction would government have grown as big as it has now, he actually argues that given the short-run pain and suffering and with the Congress we have that we would have had a far bigger government now than what we currently have. Obviously at this point, we are in a world of pure speculation, but the scale and scope of government has grown drastically in the last year as a fact; the counter-factual argument on both sides is more difficult to make.

But what Tyler does admit is that the long-run consequences of our current policy path may in fact be extremely dangerous. What I'd like to suggest is that those long-run costs MUST be incorporated into our current assessment of the situation. If what we have merely done is stave off immediate troubles in adjustment, but threaten future complete collapse, then we haven't just given ourselves time to fight another day. We have simply treated a hang-over by getting drunk again and again and again.

The end game (that Tyler and Randy) admit is a problem isn't really and "end game" as much as the way the game is played (a point Dick Wagner made to me). Once these insitutions are not contrainted to their old functions, but have new power why would they go back to the old ways (Higgs's ratchet effect). If you think of Hayek and Buchanan/Wagner as diagnosing the basic problem of monetary and fiscal policy, and Mises and Hayek (and John Taylor) as having indentified the root of the financial crisis to begin with, then we have to say that Higgs both with his concept of regime uncertainty and non-monetary distortions to market adjustment, and his identification of the phenomena of the ratchet effect in politics, probably does more to help us understand the difficulties than any other thinker. Imagine if Ben Bernanke in studying the Great Depression had focused on those aspects discussed in Higgs's Crisis and Leviathan and his articles on the Great Depression in JEH, rather than the more monetary factors, then what would his hammer had looked like when he thought he saw the nail? Applied economics without taking into account political economy is not good applied economics no matter how brilliant the economists is who is doing it. Public choice analysis is not a footnote, it requies that endogenization IF a full assessment of the costs are to be made.

I would just like to insist that in discussions of political economy, that we incorporate into the analysis at the start the sort of costs associated with the institutional transformation that is required. As you say, questions not only of scale, but of scope, and how once that scope has been increased to meet an immediate "crisis" what are the cost of restricting that scope back to previous levels. All of these costs must be considered in making an assessment of the costliness of policy A versus policy B.

So, in my mind, the way Tyler posed the original question (while an important question to pose) and more importantly the way he answered it, did not include the full cost accounting of the options. He focused more or less on short-run and direct effects, and while admitting the existence of, but not incorporating them, the long-run and indirect effect. To me these long-run and indirect effects are not just institutional (they are, and these are major issues since the scope of government has indeed grown and we don't have any good idea of how to reduce that scope), but also the unleashed cycle of deficits, debt and debasement. Our current policy path is not viable, it is like treating a hang-over by going on another drinking binge (or taking another shot of heroin if that was the drug of choice) not allowing the system to correct and return to "normal".

So I conclude that government is not the corrective, it is the cause of the crisis. And while I do think questions of scale matter (remember Buchanan's thought experiment about the fly growing 9 times its size and the question of fiscal dimensionality), the more important issues are related to scope. And once the scale and scope of government has been increased to meet a crisis, how costly is it to get government to reduce scale and scope to return to levels consistent with a regime of liberty and prosperity.

Excellent post. Another challenge might be that in the courts there is, at least relative to Congress, a lack of rent seeking in the process. In other words, it's doubtful the redistribution would so disproportinately go to voting blocks instead of those with a capital claim. Perhaps the courts would have been less sympathetic to Goldman Sachs and the United Auto Workers, etc. I could be wrong, but I have always thought of the courts as less directly corruptable than Congress.

Are we getting off track by framing the question in putatively libertarian categories such as size and scope of "intervention." Isn't the basic point much simpler? We didn't need bailouts for "quantitative easing." So the question is whether the bailouts per se were a good idea. How is it a good idea to bailout financial intermediaries that showed themselves unable to distinguish good from bad credit risks? How is it a good idea to institutional our bad habit of bailing out big enterprises? How does it promote efficiency in credit markets to artificially skew the risk profile faced by large creditors even beyond the skewing already implied by subsidized deposit insurance? And what does libertarianism have to do with any of these issues?

I challenge the view that bankruptcy law and bail-outs are different scopes of government activity but are of the same kind. Not only do we have two scopes of activity (which is discussed by Mr. Horwitz; the one old, the other 'new' scope), but insolvency procedures are 100% free-market institutions which are just organized by our governments (which makes them so inefficient and improbable that Cowen discounts them) but they are no genuine state activity like bail-outs, which violate the principles of exchange (that does not deprive them of value a priori), but are essentially grounded on power relations. I wonder why spontaneous-market economists do not rebel against Cowen equation of these two distinct government activities.

Who is Randy?

No arguments Roger, but I was trying to answer Tyler on his own terms.

What Roger said...

In this discussion I have continued to assume that FDIC exists and that it operates in the usual way and impacts what happens to credit markets and the economy. As I see it, we now are gaining the benefits of FDIC. We already bear the cost of moral hazard. And while I think the costs are greater than the benefits, I don't think the working of the system in a crisis is an additional intervention. Reaping the benefit isn't an additional intervention.

I think Cowen is haunted by the scenario of all financial institutions being insolvent at once. And they are all closed down at once, and then remained closed for a year or two, and then are gradually reopened over another year or so. Well, that could be pretty awful.

I am concerned about that scenario too, but more in the context of a free banking system. Suppose all the free banks were insolvent at once? Most of the work on free banking is about how liquidity problems could be handled. And, of course, one would hope that without moral hazard introducing institutions like FDIC, insolvency would be less frequent. But, suppose it happened? I think rapid bankrupcty would be essential.

But in today's world, FDIC means that insolvent banks can operate and FDIC can reorganize them and "create" solvent institutions. The collapse of the shadow banking system would not cause all banks to close down. The statistics on commerical bank deposits, credit, amount of interbank lending, and interest rates all show that there was no collapse in the fall of 2008. I continued to draw on my home equity line of credit when I wanted. The direct deposits of my paychecks continued. My debit card worked.

Of course, people who worked in the securitization market saw credit "freeze." The money center banks not only were paying a lot more than the U.S. government for short loans, they were paying more that what little community banks were paying. (Libor was way above the Federal Funds rate, and there were lots of Federal Funds transactions.)

Of course, the shift from the lending in the shadow banking system to T-bills and FDIC insured deposits raised the demand for money. The Fed paying interest on reserves greater than T-bill rates raise reserve demand. Monetary disequilibrium was created, and the Fed's approach to it, trying to build up the securitzation house of cards failed to prevent a rapid drop off of nominal expenditures and so the long and mild recession turned into the Great Recession. But as Roger said, quantative easing could have dealt with that, and it didn't require bailouts.

"I am concerned about that scenario too, but more in the context of a free banking system. Suppose all the free banks were insolvent at once? Most of the work on free banking is about how liquidity problems could be handled. And, of course, one would hope that without moral hazard introducing institutions like FDIC, insolvency would be less frequent. But, suppose it happened? I think rapid bankrupcty would be essential." - Bill

Wouldn't banks reserve the right to limit the redepmtion of their liabilities in extreme circumstances? It would seem like a sensible precaution to inform depositors (i.e. lenders) that during a crisis the banks may temporarily cease redeeming their notes; it would also reduce the incentive for depositors to run on the bank in the first place.

I am ignorant of any historical precendent on this matter with regard to free banking, but it seems quite an ordinary practice that debtors are, under special circumstances, permitted to temporarily stop repayments. Surely some banks would write into their contracts some clause allowing something like the same, right?

There is even more fundamental problem with Cowen's argument than his blindness for public choice considerations in this particular matter. He asks "whether we should let 1931-32 scenario to repeat", assuming that falling of price level was cause of severity of depression (I am not sure to what extent Steve would object to that specific point).

But, if this is so, how than "forgotten depression" 1920-21 came about, in which prices fell even more steeply than during Great Depression, both taxes and government spending were decreased and certainly no bailout occurred. Fed allowed quantity of money to dsecrease even more than during 1929-32 and general decline of prices was comparable. The most effective response to this Cowen's inflationist nonsense is to ask him how this "forgotten depression" passed with so little long-term economic and social costs? After couple of months of severe recession economic growth resumed very quickly, with very tight monetary policy and without any bailouts whatsoever.

But, problem with the type of Austrian approach cherished on this blog (that Cowen understands very well) is that it doesn't have specific monetary Austrian argument against inflationist nonsense (such as Cowen's own previously cited question about 1931-32), but only public choice one (bailouts increased the scope of government which is bad from libertarian point of view). At least Steve agrees with Cowen that allowing deflation during the boost is deleterious thing. And if I correctly understood Cowen, his basic objection was exactly that without bailouts we would have strong deflation and more of credit freezing.

Cowen advocates, in Friedman's footsteps, inflation plus bailouts as preferable from "libertarian" point of view, while Steve accepts the first part about "not allowing deflation", and criticizes only second part about bailouts, with public choice counter-arguments (which I consider absolutely correct,as far as they go).

But, agreement between them on monetary policy, fight against deflation, recession, credit freeze is complete. This is not disagreement about fundamental theoretical principles, but only about cost-benefit effects of some particular government policies.

@ Steve:

But Tyler was wrong to drag libertarianism into the picture. Wasn't he saying that Pete and other Austrians must be responding *not* to the economic consequences of bailouts, but to libertarian ideology? He says, "Let me nudge [Pete] (and others) again and try to make things easier for him. General pro-market or anti-government arguments don't rule out the recent bailouts." The important point to make in response to this post by Tyler is that "general pro-market or anti-government arguments" are simply not the issue. The issue is bailout vs. "quantitative easing."

By switching the issue in this way Tyler is implicitly saying that libertarianism is an "ideology" in the popular sense: An irrational belief system adhered to for its own sake without regard to facts or argument. Isn't Tyler saying, then, that libertarians are not serious folks? And, BTW, why should I, the one non-libertarian in our group, be the one to point this out?

Lawless privilege and theft on a massive scale enriching the inside elite and impoverishing the unconnected is the deep issue unaddressed here.

Paulson and Bernanke and Obama and Bush have used massive and unchecked power to transfer massive resources from my family and others
to the insider friends, associates and financiers of this lawless
political class.

The legitimacy of the whole system of rule governed just exchange is undermined by such massive acts of lawless cohercive theft by the privileged agains the unconnected.

Nikolai,

Congratulations!

Again, you have hit the nails right on their heads.

And, I would ask, not just, "Has Cowen Forgotten His Higgs," but Horwitz his Mises?

And, you, too, Greg, are right on target.

Yeah, Nicolaj, I have no Austrian monetary arguments against inflation. Right. I challenge you to find a contemporary Austrian who has written more on the cost of inflation than I have: http://www.gmu.edu/rae/archives/VOL16_1_2003/5_Horwitz.pdf

The problem is that you and I disagree on the *definition* of inflation, not that we disagree on whether inflation is bad. But you'd rather just keep throwing around your insults than deal with it more constructively.

The point I saw Tyler making about 31-32 was not about the deflation per se but about the bank failures. I don't think he was saying that the "falling price level was the cause of the severity of the depression" I don't believe that either, as stated. The causes of the severity of the depression were the size of the inflation that preceded it, the size of the fall in the money supply in the early 30s (which was both a cause and a consequence of the bank failures), and the variety of government interventions under Hoover and FDR that prevented price and wage adjustments and created regime uncertainty. Again, the falling price level is not a cause of the severity, in and of itself.

And yes, I do think the Fed erred in allowing the money supply to fall. You can define my position as "inflationism" if you want, but that's begging the question. You can accuse me of being "un-Austrian" if you want. I don't care. What I care about is good economic analysis, and I don't think self-described Austrians have a monopoly on it. (It's again worth noting that both Mises and Hayek can be found defending the monetary equilibrium view, as can many contemporary self-described Austrians, so on what ground it's not "Austrian" is not clear.)

Tyler's concern, as I read him, was preventing the cascade of bank failures that characterized 31-32. If he'd been concerned about the money supply issues, he'd have probably said 30-33, which would have covered that set of events. Historians of the GD usually focus on 31-32 when they are talking about the bank failures as that was the period they were at their worst.

Maybe if you were less concerned about defending the faith against the heretics you see everywhere and more concerned about getting at good economics, you'd see all this more clearly.

And, Greg, you're right on target, whether referring to the massive theft brought about by Cowen's bail-outs or Horwitz's inflation.

Roger,

I understand what Tyler was trying to do, but isn't part of the response to say that people who consider themselves libertarians have a response to his argument that isn't an invocation of ideology? Wasn't Pete's long comment above and his original post and attempt to say that political economy gives us analytical tools to explain why the bailouts were wrong? Isn't that how one answers the charge of "ideology" in the bad sense of the word?

I have to say that it just cracks me up to be called an "inflationist." Totally cracks me up. I wrote a book with a whole chapter on the costs of inflation (not to mention the article linked above). I do a talk on it every year at FEE. All of those argue that the costs of inflation are real and high, and that ONLY an Austrian perspective can help to see just how bad inflation really is. I've supported free banking for over 20 years because I think it would put an end to inflation.

Yet I'm still an "inflationist." If it weren't so ignorant, it might actually be "ha ha" funny instead of "pathetic" funny.

I think it was an error to respond as libertarians, Steve. Caldwell's "basic economic reasoning" does the job.

Or maybe I'm just a little sensitive to that word "inflationist". You know, like Marty McFly and "chicken." Or this guy and chicken: http://www.youtube.com/watch?v=gS6NZf7TO08

Pete,

I appreciate what you are trying to do, but it seems to me that your reply ran so far around Robin Hood's barn that you never got back to the starting point and ended up in the bushes somewhere babbling about political economy. I think part of the problem is definitional in terms of the question that Tyler posed, namely, just exactly which of the actions that have been carried out constitute "bailouts"? Is it just the TARP, or the quantitative easing through adding all those new lending facilities at the Fed, or maybe even the FDIC restructurings that we have seen, or the special (and extremely questionable) special interventions by the Fed such as the maneuverings behing getting Bank of America to buy Merrill Lynch? Just which of these constitute the "bailouts"?

Same question can be asked of Steve Horwitz. Again now, I am back to playing this "second best" game where we assume, more or less, the institutional and oranizational and legal structure that was in place last year.

In this regard, I would note that there was an earlier round between Tyler and some of those on econlog (which I am currently boycotting because I am such a cranky guy), particularly Henderson, over whether one can separate out "quantitative easing" from "bailing out banks." Tyler claims that Bernanke argues that these cannot be separated, and Tyler agrees, and I tend to side with this argument. Surely if the Fed had not established all those alternative lending facilities (that are still being heavily used by US banks, in contrast to the TARP, which is being paid back as fast as they can do it), would not many more banks have failed, or had to run to the FDIC, whose accounts would have then failed, and also what would have happened if the Fed had not taken on all that junk from Europe, without doing which would have probably triggered a wave of bank failures there?

Greg,

Given that the interventions of various sorts, whether or not labeled as "bailouts" have arguably prevented the Great Recession from turning into another Great Depression (although perhaps you disagree), then if it prevented you from being laid off, then the theft from your family does not look so awful.

BTW, I am for breaking up all those banks that are "too big to fail," but just as with free banking, the ability to that was not available and was not pushed very hard as a policy, and the recent news informs us that indeed the bigs one that did not fail, are now bigger and more powerful (and richer) than before, with indeed serious dangers of worsened moral hazard problems and at least some of the pol econ problems raised by Pete having been worsened.

There is a useful distinction to be made between positions and contexts. It seems to me that Cowen is identifying libertarians by the context in which they take a position. Two people may adopt the position that abortion is wrong, but do so within different contexts, e.g. one being a catholic and the other a hindu. Ask each man to eplain why he takes such a position, and two very different answers will be received.

I think Pete is *positionally* a libertarian with regard to the structure of government and public policy, but he takes those positions within a different context, i.e. he will give very different reasons for supporting libertarian positions. For example, Pete seems to reject the claim that his positions descend from some religious or quasi-mystical authority such as "natural law/rights."

Here again Pete seems to be arguing that opposing the bailouts is not just reflexive libertarianism in the "line in the sand" variety -- the same libertarian position can be held within another context, or more specifically, a more utilitarian concern for long-run consequences.

Pete, I preemptively apologise if I have completely misrepresented your views, but this is just how it seems to me.

The case for lending to solvent banks during a crisis is one thing, that for bailouts is quite another. I don't see the sense in which Tyler has shown the usual arguments against support of insolvent banks (let alone insolvent non-bank firms) to be inapplicable in the recent case. He seems to think that you have to lend to insolvent non banks to keep panic from spreading to solvent banks. That's simply not so: a commitment to lend to the solvent banks (or at least to those that can post decent collateral) ought to have sufficed to limit the FDIC's exposure.

Nor do I think that Tyler sufficiently appreciates how his "second best" solution will almost certainly help set the stage for bigger failures in the future. The moral hazard problem remains THE big issue in banking and finance. Maybe putting a penny in a fuse box is the "second best" alternative to replacing the wiring in a faulty electrical system. But what competent electrician would recommend it on those grounds?

Prof. Horwitz,

To Nikolaj, you said:

"It's again worth noting that both Mises and Hayek can be found defending the monetary equilibrium view, as can many contemporary self-described Austrians, so on what ground it's not "Austrian" is not clear."

But you fail to mention that Mises can also be found attacking it, and that his defense of it was in an earlier work, Theory of Money and Credit, and, his attack upon it, in a later, more considered and definitive, work, Human Action.

Why do mention just the one and not the other?

Since you dislike being called an inflationist, you too must consider inflation an evil.

But just what is this evil, inflation?

Is it an increase in prices?

Certainly not.

An increase in the supply of gold?

Certainly not.

It could only be an increase in the supply of fiat money, which you have advocated in certain circumstances.

And that, by your own definition, is an evil.

A necessary evil?

Perhaps so, and, in the circumstances, a good?

Perhaps so.

And you a good rather than bad inflationist?

Perhaps so.

But, still, an inflationist.



Steve,

words are not important. I don't want to argue with you about how do you like to call yourself (but, your taking my description of Cowen as "inflationist" as an attack on you is quite revealing. It testifies that you really share key theoretical assumptions with him, just as I said). In order to avoid to make you so angry in the future, I accept to not use "I" word never against you, and describe your position more precisely and correctly as "avoiding dangerous deflation during the bust at all cost" instead.

I just wanted to emphasize that Cowen's theoretical assumptions in monetary economics and history are very similar to yours, only your policy prescriptions are different. And I am not sure at all that starting from your shared theoretical assumptions your policy prescriptions are superior to his. That is a matter of practical cost-benefit estimate. Both of you consider bailouts as economically beneficial in averting "dangerous deflation". If Cowen is right in emphasizing potential deflationary effects of letting big banks to go bankrupt in 2008, you must agree with him that bailouts fulfilled very useful economic function. On the other hand he agrees with you that widening the scope of government is not good thing.

The difference between your and his position is only in quantifying cost-benefit ratio between economic benefits of bailout expressed in averting deflation, and long-term costs expressed in increase in scope of government activity. You are more pessimistic (think costs of government meddling far overweight benefits of preventing dangerous deflation via bailouts), while he is more optimistic. But you and Cowen define costs and benefits of bailout in exactly the same qualitative way. Both of you mean by "costs" and "benefits" the same things. Problem is that I think you are both wrong, and both economic and public policy effects of "preventing dangerous deflation" are costs. There are no benefits whatsoever, to compare with costs .

Barkley, some points:

1. I'm with Kling in believing the top of the pyramid of the financial sector needs to be "recalculated", i.e. it consumes far more wealth than it produces and it needs a giant "haircut" -- and the biggest parasites are the owners and top executive of these firms.

Solving the liquidity and confidence problem doesn't require that the parasites retain ownership and executive power -- or that trillions of dollars are added to their own private wealth.

Why wasn't liquidity pumped into the solvent banks? Why did so much of it go to the insolvent parasites looting the rest of us via AIG and Goldman Sachs?

2. The best point to stop the massive theft of wealth was in the early 2000s -- exactly when I and other Austrians were speaking out about Fed policy and all of the pathological "ownership society" institutions, such as Feddie, Fannie, Ginnie, the CRA, all of the mortgage origination fraud which the FBI refused to investigate, etc -- and everything we have learned since about the pathological regulator regime involving the "AAA" securitization of bad mortgage debt, the ratings agencies, etc.

3. The "bailout" injected money and credit into specific points of the economy -- so did the "stimulus". It _took_ money out of other parts of the economy. Most likely I was much more damaged by these distortions of the system of relative prices than I was benefited by them -- and folks on Wall Street were much more likely to keep their jobs which would otherwise be have been lost or "de-bonused, on the other hand most likely these distortions had the opposite effects on the job prospects for the members of my own family.

Brain dead "aggregate hydraulic" thinking (as Kling calls it) doesn't help much here -- relative price thinking is what really makes a difference for real people with real jobs.

Eg.g for a large chunk of workers real wages rose during the Great Depression ..

Well, that's enough for now.

Barkley writes:

"Given that the interventions of various sorts, whether or not labeled as "bailouts" have arguably prevented the Great Recession from turning into another Great Depression (although perhaps you disagree), then if it prevented you from being laid off, then the theft from your family does not look so awful."

I'll let you others bicker about techniques and I respect your opinions although I side with Steve Horowitz and Robert Higgs. The bottom line is that what was done was meant to preserve the status quo and prevent the bad actors from paying the price for their misdeeds. Why make your friends suffer when you have the sucker Taxpayers to fall back upon.

Rosser:

Your remarks are interesting, however, you seem not to understand how FDIC operates. Banks don't go to FDIC. FDIC pays off depositors in failed banks. If FDIC runs out of funds, it gets money from the U.S. Treasury. So the U.S. government sells government bonds and the proceeds are used to pay off insured deposits in banks.

Not all bank liabilities are insured deposits, and so, it is possible that there can be a run on uninsured bank liabilities of one sort of another. However, as long as people believe that the U.S. government will back FDIC, then there is no risk of loss for insured deposits. And this means that banks can fund themselves entirely with insured deposits. Leaving aside capital regulations, there is nothing stopping an insolvent bank from operating forever.

However, there are capital regulations and FDIC isn't supposed to let insolvent institutions operate. In fact, they insist they have positive net worth.

FDIC can either liquidate or reorganize an insolvent institution. And that is when there is an actual call on FDIC resources. And if FDIC runs out, then a call on the resources of the U.S. government.

If there is a scenario of massive insolvency, then FDIC will have a huge backlog of institutions it must deal with. Nothing forces the insolvent banks to shut down. Perhaps they must increase their funding by insured deposits if uninsured sources of funding disappear, but they can operate until FDIC shuts them down.

FDIC then liquidates or reorganizes banks, costing it funds (because they are insolvent) and when it runs out, then that is when there is a big "bailout" of FDIC.

Now, FDIC has traditionally coverered only insured deposits when in liquidates a bank. That means closing it down and selling off the assets piecemeal.

If FDIC responded to mass insolvency by closing down all the banks that were insolvent and then sold of their assets peicemeal, that would be a disaster. You know, close them now. And then, deal with them as they cover the backlog. Insured depositors will just have to wait.

The other approach is purchase and assumption. This is the usual approach, and FDIC covers all bank liabilities with that mechanism, and the bank stays open with new ownership.

In my view, if there is mass insolvency, purchase and assumption is the way to go. Now, that doesn't necessarily mean that all liabilites have to be covered, but keeping the bank open under new ownership is important.

Liquidating a few, small banks is no problem, because other banks can expand. But if 100% of banks, or 80% of banks, or 50% of banks, or 30% of banks (measured by share of assets, really) were insolvent, well, reorganizing them and keeping them open seems sensible.

So, FDIC just needs to reorganize insolvent banks as fast as it can. Until FDIC gets to them, they stay open. And any bailouts should be directed to FDIC.

It is possible to impose losses on those holding long term bonds in this scenario, but trying to impose losses on unsecured short term lending is futile. You can say you are going to do it, but really it will just result in a shift into insured funding.

There are some complications, but the notion that the Fed needed to bail out banks, because if it didn't the banks would go to FDIC and FDIC would run out of money, just doesn't express the role that FDIC plays in this sort of crisis.

Oh... Investment banks have no insured deposits, and so they just fail if they are insolvent. And bailouts where the Fed supports them by lending means that the current stockholders keep something (FDIC gives them nothing) and the current managers don't have the embarrasment of having had their principals.

Now, perhaps you and everyone else understood all of this, but the way you expressed the role of FDIC and the need for a Fed bailout seemed inconsistent with the way I understand it works.

Where is Tyler's argument that a nationalization of the insolvent firms -- and a permanent "haircut" for the owners and executives of these firms -- wouldn't have been better than a "bailout" regime which essentially constituted massive lawless power and privilege and massive theft from the less well off politically unconnected to the politically connected super rich?

Massive and lawless arbitrary power -- e.g. the forced J.P. Morgan/BofA deal, the takeover of GM and Chrysler by Obama & his union financiers, the massive transfer of wealth from taxpayers to Goldman Sachs via AIG engineered by owners of Goldman Sachs securities in the U.S. Treasury, etc.

Why was bankruptcy for WaMU just fine with everyone but not AIG or Goldman Sachs or Lehman -- could it be because the owners and executives of WaMu didn't have powerful peer group friends at the Fed or in the Treasury Dept. or in the White House -- folks with deep financial and political interests in their fate?

Kelly:

A lot of work has been done on how free banks would respond to bank runs. What you described is the "option clause," and it is very important. It prevents bank runs from causing banks to become insolvent. It solves the problem of banks being illiquid. However, if a bank really has made a lot of bad loans, and its situation is hopeless, and it cannot possibly recover, it should close down. Now, maybe such banks would exercise their option clause. The penalty interest would just create more liabilities that will never be repaid. But it can't be perpetual. And it looks to me that there would be motivation to take extra risks, just like with insolvent banks protected by FDIC.

The "normal" situation is that "an" insolvent banks fails, and its depositors take losses. The sound banks expand to meet the demand for both deposits and loans that is no longer met by the failed bank.

But what if all the banks are insolvent? What if 90% of them are insolvent? If there are 10 nationwide branched banks issuing notes and deposits, and all of them get the crazed notion that housing prices can never fall, so why not put 50% of our assets into home mortgages, and then the speculative bubble pops, all ten banks could be insolvent.

That is the concern. It isn't runs causing bank failure. It is bad investments causing insovlency and under free banking the money supply is much more dominated by bank liabilities.

Greg,

Let us say that we shall agree to disagree on certain points.

Bill Woolsey,

Perhaps others needed your lecture on how the FDIC operates, but I am not among them. When I referred to the FDIC accounts failing, I was thinking of it running out of money to pay off massive numbers of depositers in the face of a massive wave of outright failures of "non-solvent" banks. An alternative, not discussed here, would be to set up some kind of workout entity like the one RTC done during the S&L crisis. But, whether that is done, or the FDIC just borrows money from the Treasury, taxpayers are involved, as is the government, in this case in "bailing out" depositers in the failed banks.

"But what if all the banks are insolvent? What if 90% of them are insolvent? If there are 10 nationwide branched banks issuing notes and deposits, and all of them get the crazed notion that housing prices can never fall, so why not put 50% of our assets into home mortgages, and then the speculative bubble pops, all ten banks could be insolvent." - Bill Woolsey

That's very protectionist of you, Bill ;)

If there are 10 nationwide car manufacturers, and all of them get the crazed notion that people want to drive ethanol guzzling smart cars with Obama's face on the hood, so why not only manufacture them, and then consumers vote with their wallets for something else, all ten car manufacturers could fail. But so what? Cars don't have to be made in the U.S., and neither do banks.

Barkley,

The Fed is nominally privately owned, but remember, it was set up by an act of legislation by Congress. Moreover, it is actually controlled by a group of governors, who (I think--I might be wrong here) must be approved by the Senate. The head governor, Comrade B now, is approved by a vote of the Senate.
So in what sense is the Fed actually private?

Bill,

In the sense that the legal title to ownership rests with the member banks. The best comparison is to Fannie and Freddie before they were taken over last fall. Privately owned but extensive government privileges and involvement. "Government-sponsored enterprises" if you will. None of this, of course, is a defense of the Fed, but I do think it's correct to call it a private, as opposed to government-owned, institution.

Barkley, I get it. Arbitrary expediency dished out by a wealthy and powerful elite mostly for the benefit of the elites but in the name of the momentary good of "the little guy" -- and rules of just free exchange be damned (and with them the long term health of the civil society).

Thus it has always among those with a contempt for the institutions of a liberal society. In brief, the ends justify the means, and the hell with reliable constraints provided by traditional rules of just conduct and common law.

Ever read Hayek's essay "Principles or Expediency?" or his essays on the Rule of Law?

Barkley writes:

"Given that the interventions of various sorts, whether or not labeled as "bailouts" have arguably prevented the Great Recession from turning into another Great Depression (although perhaps you disagree), then if it prevented you from being laid off, then the theft from your family does not look so awful."

Greg,

The Great Depression brought us the election of Adolf Hitler to leadership of Germany (I understand a bit more complicated than that, but essentially correct), with 30% unemployment in Germany. There are a lot of people running around calling others Nazis right now. I am not doing that, but what I just stated is a historical fact.
Now, maybe if we had some policy last fall you (or Pete or anybody else on this list) would have preferred that did very little to prop up the financial system, we might not have ended up in another GD, so the danger was there, seriously so, more seriously so than at any time since it. Going on about how monetary policy should have been better in 2003 or whenever simply does not cut it in terms of the magnitude of the moral-historical responsibility involved here. That needed to be avoided, even at a high cost.

If Horwitz is an inflationist, then Rothbard is a statist. After all; he did favored governmentinternvetion in restoring the Gold standard!1!1!11!1!1!!1

I'm fed up with calling the monetary equilibriumtheorists inflationist, even though I still have my doubts with certain theoretical parts of it. (I'm planning on reading Horwitz 'microfoundations and macroeconomics' and I also have Sechrest his book lying around.) And I'm relativly new to this... The ME-theorists are heroes; enduring this kind of 'arguments'. :/

I wonder if a failure of banks would have actually caused something similar to the 1930's.

I've heard some make the claim that bank failures is exactly why the money supply dropped so sharply, but I'm unconvinced that this is the main cause or even that it couldn't have been fixed immediately.


I would like to look at Taylor and the Taylor rule for more guidance about Fed policy than about scare tactics that make us quick to do anything, even socialize costs while profits remain privatized, as long as we're doing something.

I think it would be much better for the Fed to get out of the role of bailing out banks and to instead focus solely on the supply of money.

I think most of us here will agree with that, but I don't know if Cowen would.

Lode,

If you don't like the word inflationist, how about expansionist? And if not expansionist, then what word would you use to describe someone who recommends expanding or inflating the money supply?

As Prof Horwitz has stated, the issue is not what word you use to describe his policy, but whether it's right or wrong.

Here, simply, is why it's wrong.

He wants to expand the money supply in order to counteract a "deflation," or fall in the general price level. But what that means, in effect, is that he wants us to run a red light.

The traffic signals of the market are telling us to STOP! There is danger ahead. You're running into a storm, and any resources you throw into it are apt to be blown away. So hold onto them until the storm passes, and still have something to rebuild with.

While the storm rages, some of our brothers and sisters are caught out in the middle of a lake.

And there is danger that their distress will spread to the rest of us. But that is only if we jump into the lake after them. The only way to save ourselves, and help them, is by staying high and dry, and throwing them a line from the shore.

The problem began with those who blew up the storm in the first place, and will not be solved by those, like Prof Horwitz, who would blow more wind into it


"And if not expansionist, then what word would you use to describe someone who recommends expanding or inflating the money supply?"

<= The use of the word 'inflating' is just begging the question. Steve Horwitz is a qualified defender of 'inflating' in the Rothbardian Definition of the word. (I hope I'm not misrepresenting his vision on the matter.) Horwitz, however, is not in favour of inflating, if you define it as 'an excess supply of money'. If you call him an inflationist, you are just assuming the thing that has to be proven, which is that 'any increase in the supply of money' is, in fact, inflation. Yes, of course: you can define it like that, but... You see the problem?

Your metaphor doesn't really help in clarifying the issue. Sorry. But it's better then keep yelling 'inflation', because that really doesn't do the trick.

Rosser:

After writing all that pedestrian stuff, I thought, surely he know this...

Of course, FDIC is government intervention. It causes moral hazard. If there is mass involvency (like the S&L crisis) limits on the ability of FDIC to deal with insolvent istitutions all at once creates an extremely bad moral hazard problem with the insolvent banks it has yet to get to. But I see no better option than muddling through. Also, having FDIC "borrow" from the government is a fiction I favor avoiding. Yes, depositors (and perhaps other holders of bank liabilities) are bailed out. The banks remain up and running through the crisis. And the owners of the banks who were responsible for selecting the managers of the banks, lose their money because of the poor investment decisions made by their agents. This is a better situation that having the government borrow money and buy stock in insolvent banks, making the banks sovlent and partially bailing out the owners. In a private market, buying stock in a firm is usually a signal in confidence in management. This is the bailout I chiefly oppose. (Well, having the government borrow money and buy bad assets from banks is no better--maybe worse.) Cowen has focused on the scenario of the Fed making loans to insovlent banks (though he wants to use to the term bailout to refer to standard lender of last resort policy of loans to solvent banks.) Anyway, that scenario, where the Fed provides an insovlent bank with sufficient funding to operate also allows the owners to keep something (if the Fed loans are on terms so that any interest cost to the Fed is less than future earnings.) I oppose that sort of bailout as well. I don't have any problem with the Fed making these sorts of loans, exactly. It is that the bank should be reoganized as explained above. The Fed might take a loss and maybe require a taxpayer bailout as well.

Steve and others,

I am disappointed to see the conversation get derailed into a discussion of whether or not Steve is an inflationist. He is not. He is thinking about monetary policy as if the Fed was able to pursue a monetary equilibrium theory set of policies --- matching money supply with money demand. But as for inflation, Steve has written very forcefully on the costs of inflation. He just also believes that "bad" deflation, causes disturbances in the economy as costly as inflation. But do note that Steve is also in favor of "good" deflation --- falling prices attributed to gains in productivity in an economy. He is not a "price level stability" advocate per se.

OK, so stop making false claims about Steve's position. But lets do challenge him (and others) on two issues --- 1 theoretical and 1 empirical. First, lets say we agree with monetary equilibrium theory, can a central banking system actually in practice manage the money supply so effectively to match money supply with money demand? I think one of the main arguments for a free banking system is that central banks face a knowledge problem in accomplishing this task (Selgin's argument). If that is indeed the case, isn't it a mistake to then ask a central bank system in a crisis to respond as if it was a free banking system and engage in a "quantitative easing" (separating it from the bailout now) to equilibrate the monetary system? If so, might it not be better to simply freeze the monetary base and allow market prices to adjust?

This brings me to the second issue -- which is empirical. Nickolaj raised this, but what about the recession of the early 1920s and the quick turn around. The understanding of the facts that was put forth in the post are in fact the facts as I understand them (are they true?) and if so, then doesn't that suggest that we would have market adjustments quickly?

So to Steve, Bill, etc. --- lets say I agree with the argument for monetary equilibrium theory (which I do), isn't the problem with a central banking system precisely that it CANNOT possibly behave in a way that would meet the demands that the theory put on it? There is a "pretense of knowledge" evident in demands to engage in "quantitative easing". In other words, when we find ourselves in the second (or third) best world, trying to pursue a first best policy with the policy instruments of that second (or third) best world results in not first best policy results, but worse than second (or third) best outcomes.

By doing what we did last fall, we have unleashed a policy regime far worse --- not just in scale and scope, but also in terms of the unchecked cycle of deficits, debt and debasement --- than had we not attempted quantitative easing (let alone the bailout).

And if you consider this perspective for a minute, then doesn't the data from the Minn Fed, etc. concerning the actual lack of a credit freeze last fall come into an entirely different light of importance?

If this story is right, then what we have done is take a market correction, turn it into a crisis through government interventionism, and then transform it into a potential catastrophe through further government interventions. And, if on the other hand, we had simply let prices do their work and guide the reallocation of resources in a market correction for bad decisions, the economy would have recovered and the Smithian gains from trade and the Schumpeterian gains from innovation would put the economy on a path of prosperity.

Why is this alternative story to the Cowen one, or even the Horwitz one, fundamentally flawed? No quantitative easying, no bailouts; no fiscal stimulus package; no new regulations. Just let insolvent banks fail, market prices adjust to changing circumstances, and tie the hands of the rulers so they cannot let political expediency guide their decision-making.

Pete,

When I've argued that "quantitative easing" might have been the right choice last fall, I've tried to do it in a qualified way that I think at least acknowledges the power of your two objections. Let me take the empirical one first.

1. I have, in print, made the point that it's not at all clear there was a "credit freeze" last fall. I agree with you that at least that point is debatable. However, the credit freeze isn't the issue from a ME perspective. The question is velocity/MD. If people *believed* that such problems existed and began to substantially increase their demands for money, especially by getting out of the banking system via currency, then we have a different problem, and one that MET would say is appropriate to respond to with an increase in the supply of money. If not, the early 30s becomes a more likely possibility. So even if lending was actually taking place, or at least hadn't "frozen," I can still imagine a scenario in which expanding the base *to some degree* was justified.

As I've also said repeatedly, the *degree* to which the base was expanded and the *process* by which it was (via the Fed taking on new tools/powers that are extraordinarily problematic) were both bad decisions. And that leads to your theoretical point...

2. Yes, the risk of giving the Fed the power to respond in the way we'd *like it to* is that it will then respond in all kinds of ways we *wouldn't* like it to. And I'll gladly admit that's exactly the problem we find ourselves in right now. This is also exactly why the point we DO agree on is so important: we need free banking. :) Giving the Fed the power to do "right" is to give it the power to do much that is wrong, and we know which is the more likely outcome. No argument from me there. But the question remains: in a world where it possesses those powers, what should it do?

I'm willing to stand by the claim that even the horrid outcome we now face doesn't ipso facto mean that a central bank shouldn't try to respond to a perceived large increase in MD by expanding the monetary base. You can point to what happened last fall as the disaster scenario, but I can point to 1987 as a case where I think the Fed got it right and we didn't get the sort of regime change you rightly fear and that we got this time. (And before the True Believers jump all over me: just because the Fed got something right doesn't mean we shouldn't get rid of it.)

So, in the end, I *do* think it's a matter of judgment. There are benefits to "doing nothing" as you say we should have. There are also risks: if the scramble for cash was real, doing nothing would have avoided what we have but might well have created an alternative (and possibly worse) disaster, in my view.

Our disagreement is over our assessment of the risks and benefits here - or over how willing we are/were to tolerate Type 1 or Type 2 errors.

To be clear: if I had been Bernanke last fall, the *most* I would have done was to use traditional central bank tools to modestly expand the base until I knew with greater certainty how real the change in V was. Yes, the Fed would find that a somewhat difficult task (the pretense of knowledge point), but if one thinks the risks of doing nothing are large enough, it's worth it.

Your argument is the best response to mine, and that my argument is better is not 100% certain in my mind, but p > .5, so I'm going with it.

"And if you consider this perspective for a minute, then doesn't the data from the Minn Fed, etc. concerning the actual lack of a credit freeze last fall come into an entirely different light of importance?

If this story is right, then what we have done is take a market correction, turn it into a crisis through government interventionism, and then transform it into a potential catastrophe through further government interventions."

Pete and Steve,

As economists, the theoretical issues of regime uncertainty, etc. may be paramount, but from a policy perspective, the empirical questions are perhaps even more important. Back in October, someone at Mises or Lewrockwell (I forget who) pointed out that in fact there was no credit "freeze," per se. (And it's not as if the Libor was infinite - banks WERE willing to lend, just not as cheaply as before.)

It has since come to light that Paulson and Bernanke were concerned about a *solvency* crisis as early as the beginning of 2008 and that they chose to wait until a perceived crisis before going to Congress to ask for bailout money. This is corroborated by Phillip Swagel's account, as well as Neel Kashkari's Charlie Rose interview. So if the regulators (and Treasury) knew that banks had solvency issues, we can assume that the banks themselves knew as well. One would expect the banks, both the solvent and the insolvent, to begin making adjustments based on this information, but clearly most did not. It would seem that they were counting on a Fed bailout, at minimum. And why not? Hadn't JP Morgan and Bear's other counterparties been bailed out in March?

I don't think any other conclusion can be drawn except the on that Pete draws here -- that govt intervention exacerbated rather than ameliorated the crisis. In this context, Bernanke's moves are "necessary" (perhaps!), not because market and political forces have forced his hand in an emergent crisis, but because of moves the Fed had already made in the very recent past. Bernanke has merely been mopping up the mess that he helped to make -- and not just in terms of keeping the Fed funds rate low during the early 2000's.

James,

I'm not denying that gov't intervention DID exacerbate the crisis. I think the debate between Pete and me is over whether standing in the fall of 2008 it was right of the Fed to engage in some degree of expansion of the monetary base. Pete says "no" because he views the errors of commission (namely the enhanced powers of the Fed, massive expansion of the monetary base and all the rest) as being worse than the errors of omission (the costs of what might have happened without that expansion). My view is that he underrates the damage possibly done by the errors of omission.

It's all a counterfactual of course, so there's no real way to settle this, not to mention it all being a problem of the second best!

Of course the fact that the Fed was even in this position is its own fault, as well as that of the rest of the intervention that produced the crisis.

Steve,

I didn't make myself clear on that point. I understand the basis of your argument with Pete, and that you largely agree with the substance of his argument about regime uncertainty, etc.

My post was made to add further empirical context and support for the arguments Pete and yourself are making about intervention and its effects on the "crisis." And I agree that it's difficult, even in hindsight, to assess the merits or demerits of expanding the monetary base at the point in which that was perceived as necessary. As a matter of methodology, incorporating empirical evidence can be messy and contentious, but insofar as professional economists are going to engage in public debates over the bailouts, juxtaposing theory with the empirical context will be crucial for convincing the unconvinced.

To take just one example (this one concerning TARP), a poster on Cowen's blog pointed out that Goldman and others had begun repaying TARP money -- but as many of you probably know, Goldman also got 13B from AIG (i.e. the US Treasury) that they will never pay back. They also sucked c. 6B in collateral calls from AIG as it collapsed -- even hastening its collapse. And, of course, Goldman and others have FDIC guaranteed debt, which in terms of taxpayer risk is no different from TARP (this was by design, of course!). And if we ever get a look at the Fed's books, we may find many people reassessing their arguments about Fed intervention last fall. We'll see.

By Godwin's Law it looks like I've won this argument ...

Barkley writes:

"The Great Depression brought us the election of Adolf Hitler to leadership of Germany"

Barkley -- As so often, you've attributed a view to me that I don't have. I tend to agree with Horwitz's view on what could and should have been done. Agreeing that the Fed is a lender of last resort, etc. doesn't at all imply that one has to believe that the super rich who made Goldman Sachs and AIG involvent should get untold additional billions from the rest of us.

Note well that Hayek was always a stable MV guy who endorsed measures to partially ameliorate the post bust "secondary deflation" (full amelioration is impossible -- do I need to explain?) Hayek even had a good word for some of Keynes various schemes for doing this, in work written in 1931 and published in 1932. Horwitz's work is in this Hayekian tradition. But that's is not saying that Pete's points aren't valid -- the knowledge / structure of production problem and the public choice problem and the incompetence problem and the personal bias problem stand in the way of a non-pathological implementation of these schemes.

Barkley writes:

"maybe if we had some policy last fall you (or Pete or anybody else on this list) would have preferred that did very little to prop up the financial system, we might not have ended up in another GD .. "

Prof. Horwitz wrote,

"When I've argued that "quantitative easing" might have been the right choice last fall, I've tried to do it in a qualified way that I think at least acknowledges the power of your two objections."

So, may I call him a "monetary easer?"

One problem with any degree of "quantitive easing" is not only the knowledge problem (i.e. where should the money go?), but also the incentive problem (e.g. political pressure to reinflate the bubble).

The problem with "monetary easing" is the same as with "monetary expansion" or "inflation," for they're all the same thing, and "easing" just a euphemism for "expansion" or "inflation."

And if there is any difference between an "easer" and an "inflator" or "expander," it is of degree, not kind, and expedience, not principle.

Prof. Horwitz is a fair weather anti-inflationist, against inflation, or easing, when things are bright and sunny, but taking cover under it at the first sign of trouble.

This differentiation between good and bad deflation is misleading. The Deflation is a symptom of the problem, not the problem, and not just a symptom, but the cure.

The problem is the storm that "government" has kicked up. The "deflation," the protection of our scarce and precious resources from the storm, is absolutely essential to the rebuilding that will be needed.

So, leave my precious deflation alone!

D.G.,

Inflation is an increase in the supply of money not matched by an increase in demand, or a decrease in the demand for money not matched by a decrease in supply. In either case the price of money decreases.

Since prices are a ratio, a general decrease in the price of money is a general increase the price everything else expressed in money. For example, if the price of 2 shirts in dollars is 10, then the price of 10 dollars in shirts is 2. If the price of 10 dollars expressed in shirts decreases to 1, then the price of 2 shirts is 20 dollars. In other words, a decrease in the price of money is also a decrease in the purchasing power of money, that is, according to our definition, inflation.

According to Dr. Horwitz, Mises himself defined inflation something like this. I am unfamiliar with Mises (I have tried to read "Human Action", but I don't find it very interesting), and, frankly, I don't much care what he thought or wrote. Therefore, it is not my desire to argue about what Mises really did or did not write, say, think, or feel.

In any case, if you understand the definition provided above, then you should be able to now understand how there can be an increase in the supply of money *without* inflation.

Free bankers argue that a free market in banking and money would have a propensity to calibrate the money supply to changes in demand, and some believe that the Federal Reserve should try and emulate this characteristic as closely as possible. Dr. Boettke is arguing that, although in principle this would be desirable, given the actual state of the U.S.'s political institutions, allowing deflation to occur would, in fact, be preferable.

Regards,
Lee

I am a bankruptcy attorney. Banks cannot obtain bankruptcy relief under current Bankruptcy laws. They have to go through the FDIC's receivership rules for distressed banks. Before that, banks were subject to the individual state's insolvency and receivership laws. But your point is well taken. There was a system created after the bank failures that plagued the Great Depression, such that distressed banks could be taken out of the economy and those are the best vehicles to take care of distressed banks.

Kelly,

I am not going to argue with you over definitions. If inflating the money supply without "inflating" prices is not inflation, what is it? Prof Horwitz has already told us what he thinks it is, easing, and expansion. If you want some other term, that's fine with me. Just tell me what it is, once and for all, so we can get past these red herrings and on to a real discussion.

Pete:

Freezing the monetary base is only tolerable if banks can freely issue currency and there is an option clause. We are not set up to operate with a frozen stock of base money.

I suppose I should study more on the 1920 recession, but "not the Great Depression" isn't the same thing as tolerable. Some of the statements by "hard money" advocates appear to be trying to prove that there will not be a permanet Depression. I would like to say that it is just a red herring (but Krugman sometimes tries to argue that there are no market forces leading to recovery.)

The recovery in the typical 19th century business cycle involved rising base money, (because of gold inflows,) money (because of an increased money multiplier, and rising prices, output, and employment.

The hypothetical scenario where there is a permanent increase in money demand, and the economy recovers though a permanently lower price level.. maybe sometime, but I don't think in 20-21. I don't doubt the logic of the process, it is just that other things changed.

Now, I think that there have been sharp increases in money demand that are temporary and have no adverse effect at all. (Imagine one week of slow business made up during the next week.) It depends on how long it lasts. And how long it is expected to last.

Anyway, if the Fed is going to monopolize base money, I think its quantity should be adjusted to meet the demand. I have no expectation they will do a perfect job. I favor free banking because I think that it is possible to harness market forces to do a better job.

D.G.,

You ask: what is an increase in the money supply that does not increase prices?

My answer: it's an increase in the supply of money!

Why do you need a special term to describe an increase in the supply of money. Do we need a special term to describe an increase in the supply of shirts?

If there were twice as many shirts in the world tomorrow as there are today *without* a matching increase in demand, then the price of goods and services (including money) in shirts would start increasing. That is, people would begin demanding more shirts in exhange for goods and services because of their sudden abundance. This would be an inflation in prices expressed in shirts (but only if demand did not also double!).

The important thing, so far as monetary economics is concerned, is not the supply of money itself, but *relative changes* in the supply and demand of money.

You have rightly said in the comments on this blog before, there is no "right" about of money for an economy. However, you have failed to understand that even when the absolute quantity of money is somewhat arbitrary, its change relative to its demand can have real economic consequences. In this analysis, both inflation *and* deflation can cause economic discoordination, malinvestment, and wasted savings.

Pete,

More articulate now. You finally made it around the barn.

Regarding 1921, this was a postwar adjustment without major problems in the financial sector. Much easier to do in contrast to 1929-30 and this most recent stuff.

The Minn Fed report in fact does show portions of the credit market in a state of major collapse, particularly the crucial commercial paper market.

Greg,

I take Friedman and Schwartz seriously regarding what happened in 1929-30. The Fed engaged in tight monetary policy, and we got the international financial crash of 1931, which was what was associated with the plunge of the global economy into the Great Depression. It is not irrelevant that this led to extreme political reactions in some of the most hard hit countries.

Kelly,

Very well, let us proceed with your terminology, "an increase in the supply of money," understanding it to be an increase in the supply of fiat money, and not real, gold and silver, money.

According to Mises, the cycle of boom and bust is started by "an increase in the supply of money," regardless of an increase or not in prices.

The greater availability of money results in a lowering of interest rates, which signals a greater desire for deferred consumption, for lengthening the structure of production, for investment with a pay-off further into the future.

If the money is real, so are the expectations, but, if the money is false, then so too are the expectations. There will not be the expected pay-off in the future.

The recession is merely the revelation of that fact, and the first step toward getting the market back on track, from unviable to viable enterprise.

So, by continuing the policy of “increasing the supply of money,” you are keeping the market off-track, and not forestalling but only delaying the ultimate day of reckoning, and making it worse than it would otherwise have been.

From Mises, Human Action, 3rd Rev Ed.:

"The services which money renders can be neither improved nor repaired by changing the supply of money…The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.” P 421

“It is possible by means of an increase in the quantity of money to delay or to interrupt this process of adjustment. It is impossible either to make it superfluous or less painful for those concerned.” P 431

I wrote, just above,

"you are...not forestalling but only delaying the ultimate day of reckoning..."

I should have said,

you are not preventing but only delaying the ultimate day of reckoning...

I think that people should ask themselves if it's worth their time to debate Austrian monetary theory, and especially what Mises had to say about it, with someone who has publicly admitted he has never read *The Theory of Money and Credit.*

Or, with someone, who, apparently, has never read Human Action, and isn't interested in reading it?

Prof. Horwitz,

I don't have audio, but I gather that you have read Human Action and think highly of it, with the exception of the passages just above.

@Steve

Well done.

So we agree about at least one aspect of Fed policy ..

But this is just once slice of a causally overdetermined complex historical episode.

You could turn your moral urgency on 1) the Fed generated artificial boom 2) Britain's return to Gold at par in 1925 3) the Hoover/FDR high wage policy 4) Smoot-Hawley, 5) the German hyper inflation 6) the rise of anti-liberal economics and philosophy in Germany 6) etc., etc.

I think my Godwin point still applies.


Barkley writes:

I take Friedman and Schwartz seriously regarding what happened in 1929-30. The Fed engaged in tight monetary policy, and we got the international financial crash of 1931, which was what was associated with the plunge of the global economy into the Great Depression. It is not irrelevant that this led to extreme political reactions in some of the most hard hit countries.

I can't take Friedman's macro seriously -- pretending that production and relitive prices and choice across time don't exist isn't serious economics.

"Data" only speak via theory -- and most "data" in econ is heavily socially constructed.

Friedman's empirical work is theory laden and -- and heavily interpreted through a
demonstrably false picture of the world.

He fails to see the artificial boom of the late 1920s ..

Once the artificial boom and massively leveraged stock market was corrected the economy had to recalculate -- the Fed then redoubled it's errors by not making enough liquidity available during the secondary deflation.

From your remarks I'd almost guess that you are wilfully attempting to fail
to get the meaning of my plain words.

I'd always thought that you knew at least a baby version of the Hayekian macro story.

Barkley writes:

I take Friedman and Schwartz seriously regarding what happened in 1929-30. The Fed engaged in tight monetary policy, and we got the international financial crash of 1931

Greg,

I agree there was an artificial boom in the late 1920s. That is why 1929 was different from 1920.

Regarding the Godwin business, this usually involves somebody suggesting that somebody else is "like Hitler" (see all the signs at the recent town hall meetings). I most certainly made no such suggestion about anybody. I pointed out that he came out of situation in Germany where there was 30% unemployment to remind folks that very unpleasant political and social consequences can happen if unemployment is allowed to become too high so as to remind that "avoiding another Great Depression" was more than just a matter of avoiding having people lose money in the stock market.

BTW, I have often brought the old boy up in arguments over free trade, as I am one of those who thinks that Smoot-Hawley played a role in aggravating the GD. I have had protectionists essentially make the same whine to me that you just did ("unfair bringing Hiter up!"). When one is talking about avoiding conditions like the 1930s, I think the nasty fellow is fully relevant to bring up, unlike, say, in discussions of some changes in national health care policy that might make us more like all the other high income countries in the world.

Just a point of clarification: was the insolvency problem a serious one among commercial banks or, at a much higher level, among investment banks?

Barkely Rosser:

"The Minn Fed report in fact does show portions of the credit market in a state of major collapse, particularly the crucial commercial paper market."

When you look at disaggregated commercial paper, you will see that high quality, nonfinancial commercial paper was fine. ATT could continue to fund its operations with commercial paper if it wanted, but commercial lending by ordinary banks was expanding during the period as well.

The shadow banking system collapsed. And commercial paper was the "deposits" of that sector and CDOs were their "loans." The collapse showed up in asset backed and financial commercial paper statistics.

The regular banking system continued to operate, presumably because of deposit insurance.
As far as monetary disequilibrium was involved, the key was to expand the quantity of liabilities of the regular banking system to meet the demand of those who were switching away from commercial paper to the FDIC insured deposits they now preferred.

As far as credit markets are concerned, the key was for ordinary banks to fund the loans they originated with their FDIC insured deposits rather than selling them to investment banks who would securitize them and hold many of them with funds raised from financial and asset backed commercial paper.

But no longer passing these funds through Wall Street was very bad for the Wall Street firms. And while I think the monetary disequilibrium could have been avoided, that is, monetary liabilities of the ordinary banking system expand with demand, the shift in credit markets would have been slower because of capital requirements, both whatever banks think they really would need and the legal requirements.

Mr. Woolsey,

You refer to "monetary disequilibrium."

What is that?

At the moment, I don't happen to have as much money as I want.

Is that monetary disequilibrium?

Or, if I see financial storm clouds gathering, and would rather keep my money in a safe place than expose it to the coming storm, is that monetary disequilibrium?


David Prychitko asks: "Just a point of clarification: was the insolvency problem a serious one among commercial banks or, at a much higher level, among investment banks?"

According to some of the best bank analysts in the industry (Chris Whalen and Josh Rosner), C, BAC, JPM, WFC were effectively insolvent by Q1 2009. The changes made this spring to FASB 157 (mark to market) changed everything. Citi, it should be noted, has a huge off-balance sheet exposures that are currently "marked to fantasy" -- most analysts assume that these will be marked down considerably whenever (if ever!) the SIV's are required to be brought back on-balance sheet. Other commercial banks have SIV issues, but Citi was the worst of them in this regard.

The short answer to the question is "We don't know for sure." Geithner's "stress tests" are almost universally viewed as a joke -- we've already surpassed the unemployment estimates in their "adverse scenario" and their baseline estimate for unemployment was taken out within a week or so of their release, if memory serves. Delinquency rates on conforming residential mortgages were lower than the rates being reported at the time of the stress tests. Plus, the bond market for these banks' debt is being guaranteed and they all have the implicit TBTF guarantee from Treasury -- so that market is useless for discovering the price of risk in lending to them.

A related point -- about half of Citi's liabilities are its deposits, while the other portion would be "in play" in the event of either a resolution or a voluntary restructuring. As badly managed as Citi was, it would be hard to imagine that this cusion isn't large enough to secure the deposits. In other words, fears that a bailout was necessary to avoid a very expensive despositor "bailout" are likely unfounded.

Barkley:

At the risk of even greater thread drift, be sure to include all the Bush=Hitler folks from a few years ago in your catalog of Godwin nominees along with the Obama=Hitler crowd of more recent vintage.

Bill W.'s answer to Dave is spot on, IMO.

D.G.,

If you are right in your interpretation of Mises, then I think Mises is wrong.

I tried reading "Human Action" and I didn't like it. The first 100 pages were a bit crap, in my opinion, so I skipped most of them. Then it improved some, but it felt like wading through a word swamp to find an occasional reward. Besides that, I find Mises's writing style vaguely offensive and frustrating to read. One problem is that Mises doesn't "speak to me". Where I agree with him, I have independently come to the same position or encountered better expositions elsewhere, and where I disagree with him he offers no answers to my objections. Reading "Human Action" was uninteresting, and I had better things to do.

In my opinion, championing Mises as a "hero of liberalism" -- or whatever it is he is called over at the Mises Institute -- is very bad PR for liberalism. I much prefer Hayek. In any case, trying to cite Mises as an authority in an argument with me isn't going to work. If Mises would have disagreed with me, then what do I care? I disagree with Mises on many things judging from "Human Action", so adding one more to the list doesn't concern me.

"According to Mises, the cycle of boom and bust is started by 'an increase in the supply of money,' regardless of an increase or not in prices." - D.G.

On this matter, I think you are wrong. (And, if you are right about Mises, then I think he was wrong, too).

If there is an increase in the supply of money and no subsequent change in prices, then the demand for money must have also increased. This is *basic* economics -- if the supply of something increases, then its price decreases unless its demand increases proportionally. What you seem not to grasp is that an increase in the supply of money, when proportional to an increase in the demand for money, means that the new money is not "false", but backed by real savings.

The boom and bust is set in motion by inflation, i.e. an increase in the supply of money not backed by an increase in demand. Intervention into the economy to repress the supply of money -- to prevent it from increasing when demand increases -- will actually be destructive to savings in a similar way that inflation is.

But this is the last I want to say on this matter here. There have been too many words already derailing this thread, and I don't think you are making an honest attempt to understand my argument or question your position. A few months ago, I would have agreed with everything you say and written something very similar -- an error I have since corrected.

Regards,
Lee

Prof. Schumpeter observed that "professors are men who are constitutionally unable to conceive that the other fellow might be right. This holds for all times and places.”

I just wonder if anyone here has ever admitted that the other fellow might right, and, particularly, that "other fellow" named Ludwig von Mises, the forgotten man in all this, honored and ignored.

Kelly,

You wrote,

“If there is an increase in the supply of money and no subsequent change in prices, then the demand for money must have also increased.”

In other words, goods are the demand for money, and, the more goods offered for money, the greater the demand for it.

Alright.

You furthermore wrote,

“an increase in the supply of money, when proportional to an increase in the demand for money (by which you mean, an increase in goods) means that the new money is not "false", but backed by real savings.”

But, with more dollars than otherwise, each of them is backed by fewer goods and less real saving than otherwise. So by creating more dollars, you are giving a false picture of real savings and creating false expectations of the viability of longer term investments. You are leading people into investments that cannot be sustained, and, when they begin to crash, you would keep them afloat with more false expectations. But you cannot do so indefinitely. Eventually, your house of false expectations will all come crashing to the ground, and the bigger the house, the bigger the crash.

Barkley. We are mostly on the same page.

I think it's hard to evaluate the relation between anti-deflation and public hiring programs and the threat of genocidal total war totalitarianism.

In it's early 30s form Keynes himself saw the National Socislist program as a good one for implimenting a Keynesian program for solving problems Keynes didn't believe the market could solve.

The "Godwin" problem comes in here because the massive evil of Hitler overwhelms and makes it impossible to evaluate anything else in seperation -- and if you do then it se to trivialize the evil.

Barkley -- our old boy Hayek agreed with you that the political consequeces of mass unemployment had to be taken into consideration by those thinking about policy.

Thanks James

I need to amend one thing.

The greater supply of goods is not the only conceivable reason for a greater demand for money.

Even with fewer goods, there may be greater demand for money. If the financial roof is falling in, you'll get your money out from under it as soon as possible, out of the market, and into a hole in the ground. That is the deflation. But it is not a bad thing. It is a necessary thing. It is necessary to conserve capital, whether in the form of physical goods, or in the form of credit, to protect them from the ravages of the rioters and looters in the legislatures and courts as well as the streets, and keep them available for the recovery, if the opportunity for it appears.

And, by the way, is it so hard to see that your inflation, whether you like the term or not, robs the savers and rewards the squanderers?

D.G.,

I don't want to discuss this with you anymore, on this blog or any other. It is enough to say that I think you are wrong, and have explained why already. There is no point in continuing, since we would merely be repeating what has already been said.

Kelly,

Sorry, but you don't get off that easy.

Would you still say that an increase, easing, expansion, or inflation of the money supply is just an increase, and not an easing, expansion, or inflation, of it?

Has anbody here seen Kelly,

Kelly of the Emerald Isle,

or, for that matter, Horwitz of it?

"Credit expansion always generates the business cycle process, even when other tendencies cloak its workings. Thus, many people believe that all is well if prices do not rise...But prices may not rise because of some counteracting force -- such as increase in the supply of goods...But this does not mean that the boom-depression cycle fails to occur...The point is that credit expansion raises prices beyond what they would have been in the free market and thereby creates the business cycle."

Rothbard, Man, Economy, and Barf, P 862

"...the depression phase is actually the recovery phase...the time when bad investments are liquidated...It should be clear that any governmental interference with the depression process can only prolong it...The depression readjustments must work themselves out before recovery can be complete. The more these readjustments are delayed, the longer the depression will have to last, and the longer complete recovery is postponed...

Many nineteenth-century economists referred to the business cylce in a biological metaphor, likening the depresion to a painful but necessary curative of the alcoholic or narcotic jag which is the boom, and asserting that any tampering with the depression delays recovery. They have been widely ridiculed by present-day economists. The ridicule is misdirected, however, for the biological analogy is in this case correct."

ib. Pp 860, 861

"The increase or decrease in the supply of money...can...lower or raise the...rate of interest although no change in the rate of originary interest (the ratio in the mutual valuation of present goods as against future goods) has taken place. If this happens, the market rate deviates from the height which the state of originary interest and the supply of capital goods available for production would require. Then the market rate...fails to fulfill the function it plays in guiding entrepreneurial decisions. It frustrates the entrepeneur's calculation and diverts his actions from those lines in which they would in the best possible way satisfy the most urgent needs of the consumers...

A sharp rise in commodity prices is not always an attending phenomenon of the boom. The increase of the quantity of fiduciary media certainly always has the potential effect of making prices rise. But it may happen that at the same time forces operating in the opposite direction are strong enough to keep the rise in prices within narrow limits or even to remove it entirely...The essential features of a credit expansion are not affected by such a particular constellation of the market data. What induces an entrepreneur to embark upon definite projects is neither high..nor low prices...but a discrepancy between the costs of production, inclusive of interest on the capital required, and the anticipated prices of the products. A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear so before...It...brings about a structure of investment and production activities...at variance with the real supply of capital goods and must finally collapse...no manipulations of the banks can provide the economic system with capital goods..The credit expansion boom is built on the sands of banknotes and deposits. It must collapse."

Mises, Human Agony, Pp 527, 547, 560, 561

Where, above, I wrote,

"The increase or decrease in the supply of money...can...lower or raise the...rate of interest although no change in the rate of originary interest (the ratio in the mutual valuation of present goods as against future goods) has taken place."

I should have written, as Mises had,

"The increase of decrease in the supply of money...can...lower or raise the gross market rate of interest..."

Prof Horwitz,

Here, again, the words of Mises, if not in Money and Credit, in Human Action.

"no manipulations of the banks can provide the economic system with capital goods..The credit expansion boom is built on the sands of banknotes and deposits. It must collapse."

So, don't argue with me. Argue with Mises, the Mises of Human Action, if not Money and Credit.

Lsvic:

You have yet to find a quote from Mises that says that any increase in the quantity of money, no matter what, leads to malinvestment.

Not all increases in the supply of credit create malinvestment, because these can reflect saving which is part and parcel of a change in the originary rate of interest.

If additional savings occurs through the mechanims of an increase in the demand to hold money, then bank lending funded by money has the same impact as increased saving through the means of purchasing corporate bonds.

If the quantity of money didn't increase, and the price level falls and the real quantity of money rises, then any credit supplied by monetary liabilities will also increase in real value. At least on first pass, the real saving and impact on originary interest is the same.

Capital goods are, of course, produced. If people reduce their purchases of consumer goods and use the proceeds to accumulate money, this frees up resources to produce capital goods.

While reading these passages I am not sure that Mises had everything right, but there is nothing obviously wrong here.


Mr. Woolsey,

You wrote,

"You have yet to find a quote from Mises that says that any increase in the quantity of money, no matter what, leads to malinvestment."

I wouldn't expect to, for as Mises explained,

"The boom-creating tendency of credit expansion can fail to come only if another factor simultaneously counterbalances its growth, If, for instance, while the banks extend credit, it is expected that the government will completely tax away the businessmen's 'excess' profits or that it will stop the further progress of credit expansion as soon as 'pump-priming' will have resulted in rising prices, no boom can develop. The entrepreneurs will abstain from expanding their ventures with the aid of the cheap credits offered by the banks because they cannot expect to increase their gains. It is necessary to mention this fact because it explains the failure of the New Deal's pump-priming measures and other events of the 'thirties."

Mises, Human Action, 3rd Rev. Ed., P 555

You wrote,

"Not all increases in the supply of credit create malinvestment, because these can reflect saving which is part and parcel of a change in the originary rate of interest."

I agree.

You wrote,

"If additional savings occurs through the mechanims of an increase in the demand to hold money, then bank lending funded by money has the same impact as increased saving through the means of purchasing corporate bonds."

I agree.

You wrote,

"If the quantity of money didn't increase, and the price level falls and the real quantity of money rises..."

What's that!? First you say that the quantity of money didn't increase and then you say that it rises. Sorry, but I can't make any sense out of that.

You wrote,

"Capital goods are, of course, produced. If people reduce their purchases of consumer goods and use the proceeds to accumulate money, this frees up resources to produce capital goods."

I agree.

Mr. Woolsey,

Let's revisit this statement of yours:

"If additional savings occurs through the mechanims of an increase in the demand to hold money, then bank lending funded by money has the same impact as increased saving through the means of purchasing corporate bonds."

If what you mean is that it doesn't make any difference whether the saver puts his money in a corporate bond or in a bank which then lends it out to the corporation, I agree.


An increase in the real demand for money unmatched by an increase in the nominal quantity of money results in a decrease in the price level. The real quantity of money rises. That is the quantity of money in terms of its purchasing power.

The first clause stated that the quantity of money is unchanged. That would be the nominal quantity of money. The second clause specified that the real quantity of money increases. If part of that money was fiduciary media, then the real supply of credit matching that money would rise as well. The nominal quantity of credit matching the fiduciary media is unchanged, but it purchases more at lower prices.

You're confusing an increase in the purchasing power of money with an increase in the quantity of money. They're not the same thing. If the total supply of money consists of 100 dollars, and the purchasing power of each one goes up, there are still just 100 dollars. There is an increase in the purchasing power but not in the quantity of money.

Those who believe that bank failures caused or where at least a major cause of the GD should always remember the contrast between the U.S. and Canada - thousands of bank failures versus zero. And yet, Canada suffered a depression slightly worse than that of the U.S.

For a better understanding of what went wrong in the early 1930s, try looking at what occured in the various labor markets.

This is important given that it was deemed necessary to ignore overwhelming democractic opinion last year, to deal with the so-called crisis, on the unproven basis that credit markets had 'seized up'/'frozen'.

It is not adequate to merely introspect on some what-if scenario like 'what if all the banks went insolvent simultaneously', and then demand that the taxpayer be forced to cover for financial firms that had behaved recklessly.

Instead, it should have been necessary for those claiming that such a doomsday scenario was at hand, to make a case for such drastic action by demonstating that a majority of banks and critical financial intermediaries were indeed about to fail.

Extraordinary claims require extraordinary evidence.

Greg Ransom - go you good thing.

I'd like to help identify one of the dimensions of the "scope" change:

Suppose that a bank goes bankrupt and the government (specifically, the bankruptcy court) steps in. In a reorganization, it would reduce the bank's liabilities to its creditors, many of whom would end up with equity. In a liquidation it would sell off the assets and pay the proceeds to the creditors. In any case, it divides up the assets among people who voluntarily interacted with each other. The only cost to people who did not voluntarily interact with the bank is the cost of maintaining the court system. This would also be true of any of the many versions being circulated of a compulsory write-down or conversion of junior debt.

Now compare that to a bail-out. In a bail-out, the government uses injects money into banks. In a Fed action, the Fed loans money into existence; if the bank fails to repay the loan, the value of the money all of the rest of us hold is diluted. Under TARP, the government borrows money from the world and invests it in the bank (by loan or equity). If the bak fails to repay the investment, the rest of us have to make it up through taxes. If the FDIC steps in, it injects money raised in taxes from other banks (or, if that reserve is inssufficient, from general taxation). In all of these scenarios, parties who did not voluntarily interact with the bank end up picking up its debts.

That is why bankruptcy (or a compulsory write-down) is better, from a libertarian point of view, than a bail-out. If you don't want to take the risk from bankruptcy, you can refuse to deal with the bank. But you can't avoid the risk of of a bail-out.

Max

To Mr. Rosser (or anyone),

I am seeking clarification regarding the structural differences between U.S. economy during bust/deflation of 1921-22 and the one that ocurred during the GD. Can you supply some specifics as to why massive deflation and rapid adjustment was possible during the 1920s without (relatively) severe economic dislocations but not during 1930s? Thanks.

I meant to write "structural differences PRIOR to bust..."

An additional comment: It was argued by someone on this blog (possible Rosser) that rapid deflation exacerbates the problems that debtors have, like folks with mortgages and this is (one reason) why deflation is bad, especially as occurred during GD. But I assume folks had mortgages in the 1920s too. It's these types of specific issues regarding the differences between the two busts that I am looking for.

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