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Excellent letter, Steve, and a clear and concise statement of your position.

Steve -
You say that increasing liquidity was appropriate, but that it was overdone. I think I am probably on board with that, but I'm guessing for very different reasons.

I'm curious - how did you come to the conclusion that it was "too much"? What helps you determine where the line is? I have to confess, I'm not really aware how Austrians make these determinations.

Daniel,

I am also curious. It seems to me that rises and falls in nominal expenditure would be the best indicator of monetary disequilibrium, but even with the Federal Reserve's expansion of the money supply, nominal expenditure remained well below its previous trajectory. That fact would seem to suggest that the Federal Reserve should have created *more* money. Steve, why do you conclude that it was too much?

Lee Kelly -
I've gathered you're an adherent to the Scott Sumner school of thought on these things.

I like a lot of what Scott has to say - he's an excellent writer and a very deep thinker. But I just can't understand this NGDP-centric way of thinking about the economy. Maybe you could explain. It seems like it requires you to be completely indifferent to, say, 6% real growth and 0% inflation, and 0% real growth and 6% inflation. How can that possibly be tenable? How could you possibly be indifferent to those two states? Am I over complicating this? Is it more just an argument that NGDP targeting will guarantee real GDP stability? If that's the argument, then (1.) that sounds more like an empirical question taht should be easy to arbitrate, and (2.) that sounds a lot more tenable. Is that basically the argument, or is there something else to it?

Just a quick reply as I'm in the middle of other things at the moment. Three points:

1. Snarky point - if you think doubling the Fed's balance sheet isn't "overdoing" it, I'm not sure what would be!

2. Several reports in the fall/winter of 2008 indicated that credit had not come to a standstill, nor that anything like a large number of banks were in trouble. Yes, some liquidity was necessary, but the notion that credit had collapsed or anything like that was simply wrong. And if you really believed that credit was in a freefall, why pay interest on reserves and raise the opportunity cost of lending?

When you tack on the point my letter was really focused on in that paragraph, which was the new powers the Fed gave itself, then the notion of "overdoing it" takes on another element as well.

3. Daniel: your second take on NGDP is closer to what I'd say. NGDP targeting, in theory, means that MV is being stabilized, which is the best environment for real GDP growth and low inflation over time. There are problems with the Fed's ability to target it, but, in theory, that's the argument.

Steve,

Although it seems as though doubling the Fed's balance sheet would be "overdoing" it, the excess demand for money appears to have persisted. So in answer to your implicit question, "overdoing" it would be when nominal expenditure (and the price level) begin rising well above their previous trajectory. Since that didn't happen, I don't believe the Fed "overdone" it. Perhaps the late response of the Fed necessitated a much greater response than would otherwise be needed?

The Fed has acted inappropriately with regard to the kind of assets it has purchased; it has no place attempting to prop up particular sectors--fiscal policy is not the responsibility of the central bank. Furthermore, the Fed neither required nor deserved any new powers, and I disagree those who argued otherwise. In this respect, I fully agree that the Fed has "overdone" it.

With regard to the so-called "credit freeze," its absence does not falsify the claim that there was an excess demand for money, but merely suggests that it could have been worse. In other words, just because there wasn't a credit freeze, doesn't mean that further expansion of the money supply wasn't in order.

I would just add Lee, that the rising price level hasn't happened YET.

I have no doubt there was an increase in the demand for money in the fall of 2008. But if you think doubling the base was either right or insufficient, that would seem to imply that you thought there was anywhere from a doubling of the demand for money to a much larger increase (given that a doubled base could support an even larger [10*new base] money supply). Do you really think the growth in MD was that large? There's no evidence I know of to support that contention.

The effects on the price level have yet to be felt mostly because of other factors that have kept the base mostly sitting as bank reserves. The payment of interest on them is one factor and the regime uncertainty inhibiting both borrowing and lending is another.

I've described the increase in the base as a ticking time bomb. Just because it hasn't blown up yet doesn't mean that starting the ignition process wasn't "overdoing it." Maybe Big Ben knows how to prevent detonation, but I haven't seen any evidence that he's willing or able to do so.

"The effects on the price level have yet to be felt mostly because of other factors that have kept the base mostly sitting as bank reserves. The payment of interest on them is one factor and the regime uncertainty inhibiting both borrowing and lending is another." - Steve

I am interpreting both of these as components of money demand (though the demand for reserves may deserve its own consideration), rather than "other factors." The increased supply of money must compensate for these *and* any additional rise in demand elsewhere.

In any case, I agree with you that we potentially have a ticking time bomb. It all depends on how quickly money demand falls, whether the Fed will pursue appropriate policy, and how fast they can implement it.

Daniel,

I agree with Scott Sumner on some things, but not others. I believe NGDP level targeting (preferably 1-3% per year) is the best possible central bank policy. However, I would first advocate abolishing any monopoly over the money supply in favour of free banking. Although I believe Sumner is sympathetic to the claims of free bankers, at present he seems to prefer central banking.

With regard to NGDP targeting. Suppose the central bank were able to stabilise nominal expenditure at its current level. In such a situation, only particular changes in productivity would drive rises and falls in the price level. (Note: it seems to me that some kinds of changes in productivity wouldn't effect prices).

Now suppose the central were able to stabilise the growth of nominal expenditure to 3% per year. In this situation, those same changes in productivity would drive rises and falls in the *rate* of inflation (with occassional deflation). In other words, the central bank would stabilise that contribution to inflation that is caused by an its money creation. The bias toward inflation offsets the bias in prices (particularly wages) to move up more freely than down.

Does that make sense? I confess that I am probably not the best person to ask. I tend to have my own rather idiosyncratic way of thinking abd writing about these things.

Professor Horwitz,

This may seem like an elementary question, but I want to avoid misinterpreting the free banker's position on expanding the volume of money to meet an increase in demand. Now that I have the time to properly learn and analyze this position I want to make sure I do it right.

Why would the extension of new money to meet increased demand not lead to a distortion of the structure of production?

Although I have read The Theory of Money and Credit, I don't feel that Mises' book is clear or direct enough to give me an accurate assessment on the effects of inflation to meet an increase in the demand for money. Is there a more modern book that you would recommend?

Thank you.

Yes, I would recommend George Selgin's *The Theory of Free Banking* for starters. My *Microfoundations and Macroeconomics: An Austrian Perspective* would be useful as well.

Think of it this way: if people are increasing their demands to hold bank liabilities (bank money), that is the equivalent of wanting to supply more loanable funds to the banking system. Holding a bank liability is a form of saving. As such, an increase in bank liability holdings causes the natural rate to fall (c.p.) as people are more future oriented. If the bank does not respond by supplying more funds for investment to match that new saving, it will be causing the market rate to be above the natural rate, and it is THAT that distorts the structure of production.

If the bank responds to the new saving by creating new funds for investment, it is doing what it should do by preventing a distortion of the structure of production and ensuring that it, in fact, matches consumers' now greater desire to save (lower TP).

Seeing the connection between money in the form of bank liabilities and the loanable funds market (and thus the capital structure) is the key.

"The effects on the price level have yet to be felt mostly because of other factors that have kept the base mostly sitting as bank reserves. The payment of interest on them is one factor and the regime uncertainty inhibiting both borrowing and lending is another." - Steve

"I am interpreting both of these as components of money demand (though the demand for reserves may deserve its own consideration), rather than "other factors." The increased supply of money must compensate for these *and* any additional rise in demand elsewhere." - Lee Kelly

Lee:

If government policies are taken to be just components of real demand, then how can the government do anything wrong according to your theoretical model?

Or, am I misinterpreting you?

liberty,

I would prefer to see the government (and the central bank) stop increasing money demand by their actions, i.e. paying interest on reserves and regime uncertainty. However, since it has happened regardless of my preferences, there is no sense in hurting everyone else by allowing a shortage of money to persist. Normally, whatever is driving a change in money demand should be irrelevent to the Fed, because a disequilibrium in the money supply will be harmful (i.e. distort the structure of production) in whatever case.

Professor Horowitz,

With the economy in its current state, and my employer looking to save money by cutting hours, I will have to wait a few weeks before I can buy George Selgin's book. Nevertheless, it is certainly on my wishlist; and I will add yours, as well.

Now, if I come off as aggressive I do not mean that at all. All I intend is to make sure I understand the argument. You write:


Think of it this way: if people are increasing their demands to hold bank liabilities (bank money), that is the equivalent of wanting to supply more loanable funds to the banking system.


Demand for money is demand to hold cash and/or demand for savings deposits, right? If the former, how does a bank distinguish those looking to use new money for consumption? If Professor Huerta de Soto is correct, that would flatten the structure of production.

Now, more importantly, if loanable funds can really be traced back to actual capital versus money, then I still do not understand how increasing the supply of money to meet an increase in demand will not distort the relative price levels of what still remains the same amount of capital. To me, when you say that meeting demand for cash increases savings, it seems as if this is really no different from credit expansion, and increase in loanable money and therefore a depreciation in the natural rate of interest.

Where am I going wrong?

My apologies, Professor Horwitz*.

"I would prefer to see the government (and the central bank) stop increasing money demand by their actions, i.e. paying interest on reserves and regime uncertainty. However, since it has happened regardless of my preferences, there is no sense in hurting everyone else by allowing a shortage of money to persist. Normally, whatever is driving a change in money demand should be irrelevent to the Fed, because a disequilibrium in the money supply will be harmful (i.e. distort the structure of production) in whatever case."
- Lee Kelly

Actually, the distortion should come if an increase in money supply is taken when in fact the consumption/savings preference of the people does not coincide with it -- this creates malinvestment that is unsustainable.

If the government has created the "demand" through various policies which may end at any moment in time, and which may have side effects or stop boosting demand even as the policies stay on the books, then responding to it with increases in the money supply is dangerous--it may lead to malinvestment.

On the other hand, demand changes that are not policy-driven are much less dangerous. Do you not agree?

liberty,

Changes in the demand for money driven by capricious government policy are destabilising.

The structure of production can be distorted by an excess supply of money, but it can also be distorted by a deficient supply of money. Both cases create malinvestment, but it manifests in different ways. An excess supply of money results in resources being squandered on bad projects, while an deficient supply of money results in resources being squandered through no use at all.

Jonathan,

It's hard to sort all of these issues out in blog comments. You might want to search back in our archives for some earlier exchanges on this.

Bascially, if you are holding a bank liability (and therefore NOT spending it), you are engaged in at least very short term saving, supplying the bank with funds it can then lend out. The whole task of the banker is to judge what portion of people's liability holdings they will keep "held" for longer periods and how much is short-term to finance upcoming expenditures. This the entrepreneurial element in banking.

There's no assurance that free bankers would get this exactly right, but they would have a mechanism for learning (reserve flows etc) whether they have over or under-done it.

There IS real capital there. When my average balance in my bank account rises, I HAVE provided savings to the banking system that it can then turn into funds for investment. I HAVE signalled my lower time preference, which is then matched by the bank lending out more at a marginally lower interest rate.

Creating more bank liabilities in response to an increased supply of loanable funds IS how the public's increased supply of capital gets into the hands of borrowers. As long as people are willing to hold more bank liabilities (whether free bank currency or deposits), they are supplying capital.

Selgin's book or mine will help here too.

Steve,
you wrote:
'As such, an increase in bank liability holdings causes the natural rate to fall (c.p.) as people are more future oriented.'

This does not logically follow. An increase in demand for holding money could just be a shift from another form of wealth holding. E.g. suppose banks held commercial bills, and investors did too. If people want more holdings of bank issued money, they can just sell their commercial bills to the bank. Their savings has not increased at all, just the savings are now being intermediated by the bank.

Shouldn't we all let the price level and money supply to contract after a boom period by the same amount of money that was created to start the boom and change the structure of production? Only when the money supply contracts even further than we have a problem. In the boom period, that new money changed the structure of production to be malinvestment at the bust. I don't inflating the money supply to boom levels so certain projects can be deemed profitable is such a great idea. But then again if the money supply falls further(as a result of policies like Smoot-Hawley) that is when a little inflation is not bad no?

Professor Horwitz,

Sorry for my persistence, but I think I finally understand. I know where the lapse in my understanding is.

You say that to meet an increase in demand for money a bank gives out liabilities. I assume these would be what we would today call bonds. The holder of the liability surrenders capital to a bank for a certain period of time, and therefore provides the bank capital to loan.

How does this translate to the Great Depression? The free-banker's argument put forth is that the central bank did not respond quickly enough to an increase in demand for money, or an increase in demand for cash holdings, and therefore did not prevent the bank-runs. How is this similar to the case you are explaining here? The clients are not looking to hold capital with the banks, but withdraw their capital.

The specific problem of the Great Depression is that the banks had lent this capital out by means of fractional-reserves and when it turned out that much of it had been squandered because of the mismatch between the artificial rate of interest and actual time-preference the banks could not return to their clients the capital they had warehoused in the banks.

In this case, I still fail to see how printing money to meet an increase in demand for money, or demand for cash holdings, would not be inflationary.

Obviously, you must have gone through this a billion times. If you prefer not to respond, that is fine. I will read those books you suggested a.s.a.p. By the way, what do you think of Larry Sechrest's Free Banking? I bought this book a little under a year ago, and read part of it, but never finished it.

David: Yes, in that case we just see a shift but no problem. The form of the savings changes but not the total amount.

JFC: "You say that to meet an increase in demand for money a bank gives out liabilities. I assume these would be what we would today call bonds."

No not bonds. Bank liabilities include deposit accounts and (under free banking) currency. Anything that's on the liability side of the bank's balance sheet. Some of those liabilities meet the need for a means of payment, like DDs and currency. When I use "bank liabilities" think "checking accounts and [under fb] currency".

Things were more complicated in the GD because people did want currency, but *under central banking systems, currency is NOT a bank liability but an asset that is part of reserves.* So yes, the desire to convert deposits to currency did much damage given fractional reserves (and yes, the Fed should have responded by creating more base money to meet that demand). BUT that's a result peculiar to central banking. Under free banking even with fractional reserves, the desire to convert deposits to currency makes no difference to the bank nor to the total stock of money.

Creating more bank liabilities when the public wishes to hold them is not inflationary because, by hypothesis, they are being *held* not *spent.* The demand for money is a demand to HOLD money balances, thus meeting that demand does not cause the total stream of spending to increase. (M goes up, but V has fallen, so MV is the same and therefore so is PQ.)

Fractional reserves are not the problem, central banking is.

And Larry Sechrest's book is very good. You should read it all.

Steve, do you think under the GFC situation, the demand was for a shift in the form or an increase in the quantity of savings, or some combination of both?

Part of the problem here is that Steve is looking at this from the viewpoint of the banker, but it's difficult for others to understand that viewpoint.

Think about it this way...

Until last week I worked for a large computer manufacturer. That company could predict future demand for it's computers quite accurately. However, each customer may not know when they will want a computer or what model it will be. However, when the large-scale seller looks at the overall situation that question can be answered with statistics to a reasonable accuracy. That company could also predict the amount of returns for certain products that it would have to deal with per month.

The same is true with cash and checking-account money. From our point of view as consumers we may spend the money at any time. But, the larger viewpoint of the banker is different. He can estimate from statistics what the half-life of a banknote will be. Though there is uncertainty like everything in life.

Curret,

In other words, de jure demand deposits are de facto time deposits, i.e. although they can be withdrawn at any time, they are can actually only be withdrawn at a particular time. The task of a fractional reserve banker is to figure out the time preference of his customers (primarily by monitoring reserves).

Lee Kelly,

That's right, but it's not really the time preference of the customers they have to find out. It's how they spend their cash and checking account money.

For example, I keep most of my long term assets in property and bonds. I keep some money in checking accounts and some in cash. However, when I move some into cash, or some into property that doesn't necessarily signal a change in my time-preference. It could be a change in response to a situation.

If I think I may need to spend a big lump of money, then I'll put more into my checking account. But, that doesn't necessarily mean that I prefer current goods over future goods more than I did. What it means is that I'm uncertain about whether I'll need to make a large payment or not. If I were certain that I would then I'd make the payment ASAP, if I were certain that I wouldn't then I'd keep my money in long term assets. Money fills the gap between those situations.

Lee Kelly,
In banking they refer to contractual maturity and expected maturity. Demand deposits are are stable source of funding for a bank, especially retail demand deposits. They are seen as sticky, and unlikely to run much even if the bank's position deteriorates. If the bank's position does not deteriorate at all, there will be no significant expected maturity at all, instead there is simply risk of variation over time. Investment in liquidity buffers provides a sure but limited size cover for liquidity risk. Investment in transparency can provide a less sure but unlimited size cover (see http://sites.google.com/site/ratnovski2/LT_new.pdf ).

Current,

Right. I was using the phrase "time preference" irregularly and apologise for the confusion. I had intended to mean depositors' withdrawals from their chequing accounts--not their desire to save per se.

Is there a way to get an RSS feed of CoordinationProblem comments?

Current,

I was waiting for someone to ask about a comment feed. I believe we can flip that switch and make them available. No one's asked before. I will take a look right now.

Steve, you should be careful in that letter to emphasize that you just have abandoned the Austrian sectarian label and renamed your blog to "Coordination Problem", and that you are not an "Austrian" economists anymore, as prof Boetke explained in the post on January 1th.

Now suppose the central were able to stabilise the growth of nominal expenditure to 3% per year.

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