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28.05.2003, 16:30

Is Easing the Answer? / Artikel mises.org

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Is Easing the Answer?
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By Frank Shostak

[May 28, 2003]

<img alt="Frank Shostak" src="http://www.mises.org/images/shostak.jpg" align="right" border="0" width="156" height="203">In
his testimony to the Joint
Economic Committee on May 21st, the
Chairman of the Federal Reserve Board, Alan Greenspan, said that the
Fed views deflation as a potential threat to the economy. For the time
being, however, the Fed Chairman believes that the likelihood of
deflation is not very high. 

Moreover, if deflation were to strike, Greenspan has
assured us that the U.S. central bank has all the necessary means to
tackle this phenomenon. Also, according to most experts on the present
paper standard, as opposed to the gold standard, deflation can be
easily countered by central bank monetary policies.

On a gold standard, when commercial banks expand
credit, it leads to price inflation, growing imports and falling
exports. This results in the outflow of gold and thus lowers the
support for paper money. This in turn raises the risk of bank
bankruptcies and therefore causes banks to curtail the expansion of
credit. The result is a decline in money, and a fall in economic
activity and prices. 

However, because the present system is not bound by
gold, the central bank is free to print as much as it deems necessary
to lift the economy and prevent price deflation—or so experts say. 

Moreover, according to experts there is no need to
be concerned with the possibility that on account of monetary pumping
short-term interest rates will approach the zero level and thereby
diminish the U.S. central bank's ability to reflate the economy. What
matters is the amount of money injected. 

More money, so it is held, will lift consumer and
business expenditure, which in turn will revive the economy. Monetary
pumping, according to experts, will also arrest price deflation and
this in turn will arrest people's tendency to postpone buying, thus
helping to kick start general expenditure in the economy. In short,
what matters here is that more money must be injected to prevent the
emergence of deflation. This is precisely what the Fed can do
according to the experts.

Some economists, however, are of the view that there
is a need to alter the present emphasis of monetary policy. According
to this view the Fed may be limited in loosening its monetary stance
effectively because the U.S. central bank targets interest rates
rather than money supply. In other words, in order to maintain a
particular interest rate target the Fed's monetary pumping must take
into account banks' demand for reserves, which are in turn determined
by bank lending and economic activity. 

So if the economy weakens and demand for reserves
follows suit, in order to prevent a fall in the Fed Funds rate below
the target, the Fed will be forced to slow down, or even contract
monetary injections. According to Milton Friedman this is precisely
the error that the U.S. central bank committed during the 1930's when
a low interest rate was interpreted as an indication that the monetary
stance was easy<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn1" name="_ftnref1">[1]</a>. 

Hence critics argue that what is needed now is to
move rapidly towards targeting the monetary base and not interest
rates. According to a Joint Economic Committee study,

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">

In pursuing an easier monetary policy stance, for
example, the Federal Reserve would expand the supply of reserves
until this easier policy stance registered on intermediate
indicators or guides deemed reliable in low inflation environments.
Monetary aggregates or market price indicators might serve this
latter purpose. Reserves could be increased, for example, until
some specified reflation occurred in broad commodity price indices,
thereby signalling that deflation concerns are on the wane.<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn2" name="_ftnref2">[2]</a>

[/i]

In short, the Fed should pump as much as it takes
until prices and economic activity start moving ahead. Once this
framework is adopted the whole issue of interest rates falling to nil
becomes of secondary importance, since what matters is the increase in
money supply.

[img][/img]

The belief that this is the right policy to overcome
an economic slump on account of price deflation emanates from Milton
Friedman’s and Anna Schwartz’s research, which concluded that the
reason for the Great Depression of 1929-1933 was the failure of the
Fed to prevent a collapse in the money supply.<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn3" name="_ftnref3">[3]</a>

At the Conference to honor Milton Friedman's 90th birthday,
Fed Governor Bernanke promised Friedman that the Fed will not make the
same mistake again.

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">

Let me end my talk by abusing slightly my status
as an official representative of the Federal Reserve. I would like
to say to Milton and Anna: Regarding the Great Depression. You're
right, we did it. We're very sorry. But thanks to you, we won't do
it again.<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn4" name="_ftnref4">[4]</a>

[/i]

In short, it seems that the Fed is likely to act
aggressively on any sign of emerging price deflation. Fed policy
makers are so confident that Milton Friedman's prescription is the
correct way to tackle an economic depression that they are not even
ready to consider the possibility that this prescription may actually
make things much worse.

If Friedman's way of thinking is correct, why hasn't
it worked in Japan, which for over a decade now has been struggling to
stage a meaningful economic recovery? In fact according to the latest
Bank of Japan report on the economy, the economy is continuing to
deteriorate. 

The usual response from the adherents of monetary
pumping is that the Bank of Japan (BOJ) has not done enough—it
hasn't been pumping enough money. But how can this be, if in July 2001
the yearly rate of increase in monetary pumping, as depicted by the
BOJ balance sheet, stood at over 44%? If one allows for lags from
rises in monetary pumping to economic activity surely by now the
Japanese economy should have been booming. 

The view that more money can revive an economy is
based on the belief that money transmits its effect through aggregate
expenditure. With more money in their pockets, people will be able to
spend more and the rest will follow suit. Money, then, is seen as a
means of payment and means of funding. 

Money, however, is not a means of payment but the
medium of exchange. It does not have life of its own; it only enables
one producer to exchange his produce with another producer. Means of
payments are always real goods and services, which pay for other goods
and services. All that money does is to facilitate these payments. It
makes the payments for goods and services possible. 

Thus a baker exchanges his bread for money and then
uses money to buy shoes. He pays for shoes not with money but with the
bread he produced. Money just allows him to make this payment. Also,
note that the baker's production of bread gives rise to his demand for
money.

When we talk about demand for money, what we really
mean is the demand for money's purchasing power. After all, people
don't want a greater amount of money in their pockets so much as they
want greater purchasing power in their possession. 

On this Mises wrote,

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">

The services money renders are conditioned by the
height of its purchasing power. Nobody wants to have in his cash
holding a definite number of pieces of money or a definite weight of
money; he wants to keep a cash holding of a definite amount of
purchasing power. <a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn5" name="_ftnref5">[5]</a>

[/i]

In a free market, in similarity to other goods, the
price of money is determined by supply and demand. Consequently, if
there is less money, its exchange value will increase. Conversely, the
exchange value will fall when there is more money. In short, within
the framework of a free market, there cannot be such thing as"too
little" or"too much" money. As long as the market is
allowed to clear, no shortage of money can emerge. 

Consequently, once the market has chosen a
particular commodity as money, the given stock of this commodity will
always be sufficient to secure the services that money provides. Hence,
in a free market, the whole idea of the optimum rate of growth of
money is absurd. 

According to Mises:

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">

As the operation of the market tends to determine
the final state of money's purchasing power at a height at which the
supply of and the demand for money coincide, there can never be an
excess or deficiency of money. Each individual and all individuals
together always enjoy fully the advantages which they can derive
from indirect exchange and the use of money, no matter whether the
total quantity of money is great, or small... 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. <a title href="http://www.mises.org/fullstory.asp?control=1237#_ftn6" name="_ftnref6">[6]</a>

[/i]

In a market economy the purpose of production is
consumption. In other words, people produce and exchange with each
other goods and services in order to promote their life and well-being—their
ultimate purpose. This in turn means that consumption cannot arise
without production while production without consumption will be a
meaningless venture. Hence in a free-market economy both consumption
and production are in harmony with each other. In short, in a
free-market economy consumption is fully backed up by production. 

What permits the baker to consume bread and shoes is
his production of bread. Thus a portion of his bread goes to his
direct consumption while the other portion is used to pay for shoes.
Note that his consumption is fully backed up, i.e., paid by his
production. Any attempt then to elevate consumption without the
corresponding production leads to unbacked consumption, which must
come at somebody else's expense.  

This is precisely what monetary pumping does. It
generates demand which is not supported by any production. Once
exercised, this type of demand undermines the flow of real savings and
in turn weakens the formation of real capital and stifles rather than
boosts economic growth. 

It is real savings and not money that fund and make
possible the production of better tools and machinery. With better
tools and machinery it is possible now to lift the production of final
goods and services, and this is what economic growth is all about.

Contrary to the popular way of thinking, setting in
motion an unbacked-by-production consumption by means of monetary
pumping will only stifle and not promote economic growth. This is
because unbacked consumption will weaken the flow of real savings and
thus weaken the source that funds real economic growth. If it had been
otherwise then poverty in the world would have been eliminated a long
time ago. After all everybody knows how to demand and how to consume. 

The only reason why in the past loose monetary
policies seemed to grow the economy is because the pace of real
savings generation was strong enough to absorb increases in unbacked
consumption. 

However, once the pace of unbacked consumption
reaches a stage where the flow of real savings disappears all together
the economy falls into a depression. Any attempt by the central bank
then to pull the economy out of the slump by means of more pumping
makes things much worse, for it only further strengthens unbacked or
nonproductive consumption, thereby destroying whatever is left of real
savings.

The collapse in sources of real economic growth
exposes commercial banks’ fractional reserve lending and raises the
risk of a run on banks. To protect themselves, banks curtail their
creation of credit out of"thin air." Under these conditions
further monetary pumping cannot lift banks’ lending. On the contrary,
more pumping destroys more real funding and destroys more businesses,
which in turn makes banks reluctant to expand lending. 

Under these conditions banks would likely agree to
lend only to creditworthy businesses. However, as an economic slump
deepens it becomes much harder to find many creditworthy businesses.
Even more, good businesses, on account of price deflation, are
reluctant to borrow. Furthermore, on account of loose monetary policy,
the low interest return against the background of growing risk further
diminishes banks’ willingness to expand credit. All this puts
downward pressure on the stock of money.

Hence, the central bank may find that despite its
attempt to inflate the economy, the money supply will start falling.
Obviously the Fed could offset this fall by aggressive monetary
pumping. The central bank could monetize the government budget deficit
or mail checks to every citizen of the U.S. All this, however, will
only further undermine real savings and devastate the real economy. 

Can one be certain that Alan Greenspan will go all
the way to pre-empt price deflation? It seems that this may be the
case if economic indicators continue to display further weakening. One
can only hope that the economy can stage an economic recovery soon—otherwise
the implementation of misguided ideas are likely to set back the U.S.
and world economies for many years to come.

<hr align="left" width="33%" SIZE="1">

Frank Shostak is an adjunct scholar of the Mises
Institute and a frequent contributor to Mises.org.  Send him MAIL and
see his outstanding Mises.org Daily
Articles Archive. Special thanks to Michael
Ryan for his comments. Follow
the dollar and the markets at Mises.org. 

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<div id="ftn1">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref1" name="_ftn1">[1]</a>
Friedman, Milton, and Anna Jacobson Schwartz. 1965. The
Great Contraction 1929-1933. Princeton, N.J.

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<div id="ftn2">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref2" name="_ftn2">[2]</a>
Jim Saxton, Vice Chairman Joint Economic Committee United States
Congress May 2003.

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<div id="ftn3">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref3" name="_ftn3">[3]</a>
Friedman, Milton, and Anna Jacobson Schwartz. 1965. The
Great Contraction 1929-1933. Princeton, N.J.

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<div id="ftn4">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref4" name="_ftn4">[4]</a>
Remarks by Governor Ben S. Bernanke on Milton Friedman's Ninetieth
Birthday, November 8, 2002.

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<div id="ftn5">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref5" name="_ftn5">[5]</a> Mises,
Ludwig von. 1966. Human Action, 3rd rev. ed.
Contemporary Books. P. 421.

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<div id="ftn6">

<a title href="http://www.mises.org/fullstory.asp?control=1237#_ftnref6" name="_ftn6">[6]</a>
Ibid.


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