There is a story from the Cold War era about a Soviet official who travelled to London. As he was shown around he couldn’t believe how full the shops were of all sorts of produce. Amazed by this bounty, he eagerly seized his guide and asked “Who is in charge of the bread supply to London?” The baffled reply came – “No one”.
I was reminded of this story and how, from the Austrian viewpoint, economics is about coordination, at an excellent talk I heard in east London last Thursday night by Steven Baker, MP and Cobden Centre board member.
He made the point that this was one of the issues we fought the Cold War over. Unlike the communist east, the capitalist west believed that economies were better organised by the millions of individual decisions taken in a free market on a second-by-second basis than they were by planners ensconced in offices pouring over reports.
The outcome was that Mises, Hayek and others were proved right. Communism collapsed and socialism was rejected. Free markets were reaffirmed under Margaret Thatcher and Ronald Reagan and the planners were pensioned off.
Except, that is, in one vitally important area. In the Monetary Policy Committee of the Bank of England, the Federal Reserve, and the Executive Board of the European Central Bank, the planners still cling on, fixing the price of credit: the interest rate .
It is crucial for people to understand that what central banks with boards of price setters represent is not a free market but what Baker called “monetary socialism”. And the central planners have proved no better at setting the price of money then they ever were at setting any other price.
It was the driving down of interest rates by these planners which flooded the financial system with liquidity after the twin shocks of the bursting of the internet bubble and 9/11. It was this liquidity, hosed about by the planners, upon which the housing market floated to ever giddier heights. And it was when the planners acted to raise interest rates to counter the inevitable inflation they had caused that the bubble burst. It was not capitalism but monetary socialism which failed.
Economists of the Austrian School are highly sceptical of the possibility that this central planning of money will produce optimum results. They are cognisant of the long and dismal history of such central planning in other spheres, and their theories have been borne out by recent experience. The Austrians were right about socialism not working. And they have been right about monetary socialism not working.
 was “price of money”; thanks to David Friedman for the correction
I don’t think we fought the Cold War over the value of market forces. We fought for strategic reasons, we fought against authoritarianism and above all fought simply out of an underlying nationalism. Market did prevail over Soviet socialism, but in an age where Western governments extended their control of the economy and their role in service provision. Remember 2008? the market doesn’t always work. In fact ‘the market’ in a true sense, like socialism has never existed.
“the planners still cling on, fixing the price of money: the interest rate.”
A common and important error.
The “price of money” is the inverse of the price level–if an apple costs fifty cents, a dollar costs two apples. If the interest rate was the price of money, an interest rate of 5% would mean I could buy money at five cents on the dollar. I can’t.
The interest rate is a measure of the cost of present money measured in future money; if it is 5%, that means that it will cost me $1.05 in money paid out a year from now to buy $1 now.
The point matters. If the interest rate were really the cost of money, then printing more money would automatically bring down the interest rate–and many people seem to assume that to be the case. Since it is the ratio of costs between money now and money in the future, reducing the value of both by increasing the amount of both does not change it.
Of course, if the government chooses to print money and loan it out, thus increasing the supply of present money offered in exchange for future money, that will affect their relative price–but the same would be true if the government lent out money it had collected in taxes.
Good Evening David,
Should you be minded to post anything on the time preference theory , you are most welcome to send in. I use this in my writings on this site when explaining capital formation . It is something we need to keep explaining .
Those who think that only monetarists would think such a thing are recommended to read p.403 of Human Action.
Thanks David. Now corrected.
All borrowed ‘printed’ money ultimately has to be paid back with ‘real’ money i.e. money that people have laboured for is the rub. Banks print money whilst we work to earn that very same money and still they fail! This cannot be an accident.
Monetary nationalist here.
I totally agree that the Fed was both ignorant and lame in that Greenspan era, and their monetary policies could only have been worse were they the absolute reverse. But, I fail to understand the “socialism” part.
What part of the Federal Reserve is socially-minded, or even social-like? The Fed is the epitome of the aristocratic anti-social richie-rich’s of the world.
They are a bunch of private businesspersons, corporatists that are self-selected to the top of the heap, and given a public money creation privilege from which to reap their richness.
Thus, all wealth to the top five percent.
Give me a break.
The Fed generally follow New Keynesian policies. If you read a book on macro it will explain the principles.
I’m not convinced that the Fed are corrupt or in the pockets of bankers. They are simply doing what conventional economic theory recommends. Where they vary from convention they vary in the direction of Ben Bernanke’s own views.
What part of socialism is socially-minded, or even social-like?
Im using socialism to mean an arrangement where some central authority has the power to interfere with private human action in the name of some greater common good. In that sense the Federal Reserve and Bank of England is exactly socialism. As I say, they are the last of the great price fixers who were so ubiquitous in the communist world.
The fact that wealth accrues to the top five percent in a system does not mean that system cannot be described as socialist. Did Mao starve during the Great Leap Forward? Did you see the Politburo lining up for their potato ration in the streets of Moscow?
Give me a break.
John Phelan might be throwing a baby out with the bathwater here, and for the following reasons.
Prior to the crunch, excessive borrowing and lending were taking place, which was driving property prices up to unsustainable levels. Had the authorities seen this their initial knee jerk reaction would have been to raise interest rates. Then, a few seconds later, they’d have realised that demand was not excessive, and inflation was more or less under control. Thus cutting interest rates would have caused unnecessary unemployment: a dilemma.
That indicates to me that adjusting interest rates is not a good tool for regulating demand. The rate of interest is simply the price of borrowed money, and if governments stop interfering with it, the optimum rate of interest will be achieved, unless someone can show there is market failure in this area.
If governments want to regulate demand, they should (surprise, surprise) demand more goods and services: i.e. spend more. Plus they should induce the private sector to demand more by cutting taxes. This is the method of regulating demand advocated in Modern Monetary Theory and by the submission to the Independent Banking Commission by Prof R.A.Werner, Positive Money and the New Economics Foundation. I agree.
In other words I suggest the failure of “monetary socialism” derives more from the fact that governments have chosen the wrong tool for the job, rather than that governments are so hopeless at regulating demand that they shouldn’t even try.
I assume by demand you mean real or nominal output. That is something very closely related to the interest rate. It’s also closely tied to the demand-for-money, which is itself related to the interest rate.
Since we have David Friedman in this thread it’s worth mentioning one of his father’s greatest ideas, the permanent income hypothesis. If a tax rate changes, but people expect it to change back in due course then their behaviour will be different. If my income falls now I will not cut my spending much, I will only cut it if I think the income fall will be permanent. The same applies for a rise in income, I will only raise my level of spending if I think the income rise will be permanent. So, the effectiveness or otherwise of this policy depends entirely on expectations. It can only work perfectly on very short-sighted people.
I had the great pleasure of learning that as a 17 year old at Hammersmith and West London College in my A Level economics , where we flew the red flag over our building and the Labour Party did not even form on campus, it was the domain of the Socialist Workers Party! Friedman even penetrated there!
David, if you are still following this thread, your old man was a great inspiration to many of us and long may the vast majority of all his writings / teachings be debated and discussed – and yours to. Part of our mission here is to promote the education of the pro Liberty Schools of Thought that are often neglected.
Ralph, what makes you believe that they won’t mess this up as well?
Thanks for the kind words John.
There is a market failure, of a sort.
Suppose the Federal Reserve fixes the monetary base and stops paying interest on excess reserves. What can go wrong?
The interest rate on base money is not a market price: it is fixed at zero. When the demand for liquid assets rises, their interest rates fall, but they cannot fall below the interest rate on money. Why would someone exchange money for liquid assets and receive a negative interest rates when they can just hold the money instead? Even if the demand continues to rise, their interest rate cannot fall, and no more liquid assets are supplied.
What we have here is a price ceiling, and there is a shortage of liquid assets at the fixed price. The frustrated demand has to go somewhere. What do people who would have bought liquid assets do instead? If demand spilled over into increased demand for flat-screen televisions, then it would not be such a big deal. A misallocation of resources, perhaps, but not a recession. However, the frustrated demand is more likely to spill over into another liquid asset: money.
This describes an increase in desired cash balances, i.e. an increased demand for money, i.e. a fall in the velocity of money. Money is being drawn away from its use as a medium of exchange and instead being used as a store of value. All prices predicated on the previous level of nominal expenditures are now “false” and we have a recession. This could all have been avoided if the supply of money had been increased to offset the rising demand.
Clearly the central bank needs some control over the supply of base money to ensure this situation never happens, right? Well we have that, and all this still happened … twice. So Bernanke and his chums aren’t the solution to this particular problem, but then what it? The problem doesn’t just go away.
Perhaps Bill Woolsey has the answers.
“This describes an increase in desired cash balances, i.e. an increased demand for money, i.e. a fall in the velocity of money. Money is being drawn away from its use as a medium of exchange and instead being used as a store of value. All prices predicated on the previous level of nominal expenditures are now “false” and we have a recession. This could all have been avoided if the supply of money had been increased to offset the rising demand.
Clearly the central bank needs some control over the supply of base money to ensure this situation never happens, right? Well we have that, and all this still happened … twice. So Bernanke and his chums aren’t the solution to this particular problem, but then what it? The problem doesn’t just go away.”
Good Morning Lee,
If people hold more liquidity, prices will fall on the whole right. What is the problem with this? Is this not what freely consenting adults want to happen? They hold more liquidity as they are more unsure of the future than before, they are more uncertain about the sustainability of prices as they currently manifest themselves. In short, they want to drive this correction. When prices are aligned better to their expectations , they start to lower their cash balances again.
What happens when the natural rate of interest is negative? The market rate will be stuck above the natural rate; markets will fail to equilibrate the supply and demand for loanable funds; this will manifest as a fall in aggregate nominal expenditures.
While deflation will, eventually, equilibrate the supply and demand for money and, in turn, the supply and demand for loanable funds, during the interim period prices will be sending false signals. History tells use that such conditions create political turmoil and, normally, calls for bigger government. Even when all the dust has settled, such fluctuations in the price level are disruptive to the plans of savers and borrowers. Money is both the unit of account and the medium of exchange. While
What happens when the natural rate of interest is negative? The market rate will be stuck above the natural rate; markets will fail to equilibrate the supply and demand for loanable funds; this will manifest as a fall in aggregate nominal expenditures.
While deflation will, eventually, equilibrate the supply and demand for money and, in turn, the supply and demand for loanable funds, during the interim period prices will be sending false signals. History tells use that such conditions create political turmoil and, normally, calls for bigger government. Even when all the dust has settled, such fluctuations in the price level are disruptive to the plans of savers and borrowers. Money is both the unit of account and the medium of exchange. While deflation may, in this instance, restore money’s role as the medium of exchange, it also corrupts money’s role as the unit of account.
If the interest rate on money could rise and fall as with other assets, then all these problems could be avoided without deflation. When interest rates on liquid assets approached zero, the interest rate on money would go negative, and at the negative rates of interest more liquid assets would be supplied. The market and natural rates of interest would equilibrate; there would be no fall in aggregate nominal expenditures; changes in the price level would be unnecessary.
In any case, just because deflation may be the consequence of the actions of “freely consenting adults,” it does not follow that deflation is the intended consequence of their actions. For example, when the U.S. enacted prices controls on gasoline in the 70s, the consequence was long lines at pumps and shortages. Given the price controls, one could describe those circumstances as the emergent consequence of actions chosen by “freely consenting adults.” Nobody intended to create long lines at pumps or shortages, and nobody intends to create deflation by demanding liquid assets. People may be “unsure about the future” and “the sustainability of prices,” but it’s the relative, no absolute, prices which they are concerned with. Deflation doesn’t help, but rather it just adds noise to the price adjustments that are already occurring.
Having a natural rate that is negative is not a possible situation. Human action always dictates that we value our most urgent needs now and least urgent later right?
So the profile of my time preference reflects this and hence I will pay a £1 for something now to give £1.05 for something later.
This is a facet of me being a human. I always need to act. To not act is to not be human.
I can’t therefore consider situations that will never happen in our human world.
If rate of interest for loanable funds is set higher than the natural rate, then chaos will ensue. No messing about with minting up more money will sort this out. Best to learn the lesson and not do in the first place. If this is suggested as a policy response to prior action, then it will sow the seeds for the next boom bust as people over adjust back their money balances.
Money IS the medium of exchange , therefore it has derived functions from this such as unit of account and store of value always.
It’s not just possible for the equilibrium rate of interest to go negative, it is happening right now! With inflation at around 2 percent, a T-bill with 1 percent nominal returns is getting about a -1 percent real returns. That is, people are willing to accept negative real returns in order to defer consumption. When the interest rate on money is fixed at (or just above) zero, this can only occur with inflation. If the interest rate on money could rise and fall, then the nominal rate could just go to -1 percent without inflation.
More later, I don’t have time to respond right now.
Remember, the natural rate can only be positive for the reasons I have stated in the above.
What you must be referring to is the various money market rates, this is another matter .
Recently you criticised me for using the concept of “maturity” in discussing FRB. You equated maturity to equilibrium and pointed out that no economy reaches equilibrium. As I said then, in FRB theory we only use an approximate and short-run concept of equilibrium. That’s something quite defensible and used by economists of all sorts, including Austrian economists all the time.
Now, the theory that time-preference determines the interest rate requires a much stronger condition. It requires that no futher productivity improvements, or improvements from entrepreneurship, can be achieved. The pure time-preference theory of interest is a theory of the hypothetical evenly-rotating economy, not the real economy. If you look in Human Action you’ll see Mises is quite clear about this.
In the dynamic conditions that exist in actual economies time-preference isn’t the only factor that affects the interest rate. We have shifting supply and demand for credit and many factors influence the interest rate that results. Expectations about the future price level and expectations about future productivity are particularly important.
To begin with, in case you’re not reading every word from around here, I’m “Current” on other forums. I changed to using my real name over here.
I’m not really that worried the problem you describe.
I think that the threat of the zero lower bound is exaggerated. In a discussion with Dan Mosley recently I discussed this a lot:
I also think that the experience of the past few years doesn’t transfer to regimes where base money is a commodity. Since the crisis began there has been much uncertainty over the future price-level. That happened because the Central Banks so clearly messed-up at the start of it. Their reputations for careful management of prices was seriously damaged. I wondered at the beginning of the crisis if inflation targeting or the Taylor rule would survive. Up to now I don’t think those things have survived, the BoE, for example, aren’t really targeting headline inflation anymore. In the US it didn’t help that statements from the Fed in 2009 & 2010 often weren’t clear, sometimes they seemed to be fearing deflation and sometimes fearing inflation. In this situation drawing up debt contracts is difficult and liquid assets are more attractive. (We mention this on ~p.18-22 of the paper we just posted about).
In an international commodity standard the international element is quite different to a fiat system.
I’d describe this more, but I’m quite busy. I know you know enough about this stuff to fill in the blanks.
Lee, I think the flaw in your argument comes where you say “Even if the demand continues to rise, their interest rate cannot fall, and no more liquid assets are supplied.” Half the point of the Modern Monetary Theory / Werner policy I mentioned above is that when demand is deficient, government spends new money into the economy: i.e. more liquid assets ARE supplied.
You then say “This could all have been avoided if the supply of money had been increased to offset the rising demand.” Agreed! I.e. you are implying that the MMT/Werner policy (or something like it) is a good one.
Finally, you ask why we continue to have problems despite Bernanke & Co having control of the monetary base. My answer is that all B & Co can do is to increase the monetary base by buying government debt (QE). That is a pretty feeble tool because it just consists of swapping two assets which are not greatly different to each other: cash and government bonds. It does not significantly increase the private sectors stock of liquid assets or “net financial assets” to use the phrase the MMTers tend to use.
The MMT/Werner policy is a different kettle of fish: this DOES increase the private sector’s net financial assets. To be more exact, for every £X of MMT/Werner spending, private sector assets rise by £X.
Toby Baxendale asks what makes me think government wont “mess this up as well”. My answer is that I’m far from 100% confident about government’s ability to organise anything, piss-ups in breweries included. But I think the political reality is that come a recession, there will always be an unstoppable demand for government to “do something”. So we might just as well try and work out what the best or least hopeless thing is for government to do.
Rob Thorpe claims that interest rates ARE closely related to demand. I doubt it and for several reasons. 1. There is no relationship between central bank rates and credit card rates. 2. The relationship between central bank rates and long term rates is very weak, and it’s long term rates that are critical for anyone making a long term investment, like buying a house or building an office block. 3. The Radcliffe Report into monetary policy in the 1960s cast doubt on the effectiveness of interest rates.
I’ve listed several more reasons for doubting the effectiveness of interest rates here:
Rob then cites the Ricardian argument that “If a tax rate changes, but people expect it to change back in due course” their level of spending won’t change. This idea is just not born out by the evidence. That is the evidence is that when people come by windfalls, they spend a significant proportion of the money (hardly surprising, I would have thought). See the following research:
Moreover, the money spent into the economy under the MMT/Werner policy would for the most part NOT be taken back via increased future taxes, i.e. deficits would be a more or less permanent feature under such a system. But deficits have been a more or less permanent feature for at least a century! And the reasons are simple.
First, and expanding economy require an expanding monetary base, and that can only come from a deficit. Second, assuming we achieve approximately the 2% target rate of inflation, that means the national debt and monetary base will decline in REAL terms at 2% a year relative to GDP. Assuming those two are to remain roughly constant relative to GDP in REAL terms, they will have to be “topped up”. And the topping up money can only come from a deficit.
Yes, credit card rates are not closely related to interest rates. Also, as you say, long term investments are not closely related to prevailing central bank rates. These fact though don’t establish that there is no connection. We have a market in loans and the prices of loans, the interest rates, vary. My own mortgage is tied to the Bank of England base rate, it’s 0.45% above the base rate, which means that for the past couple of years I’ve been paying 0.95%. Does that affect my decisions, you bet it does. There are many other variable rate loans. Often saving is variable rate, while borrowing is fixed rate. This though doesn’t remove the issue, since the difference is the profit of the bank and is used to expand the bank or paid to shareholders.
The main issue in our current system isn’t the effect that monetary policy has on short-run interest rates. That’s simply the first step. Central banks lower the interest rate by creating reserves which allow the commercial banks to create more money, they increase it by the opposite process. That increase in money supply then affects all other sectors as it spreads to them, that’s the first large effects. The second is the “broad” rate of interest, the interest rate that is built into all investments. If the money-market interest rate were the only interest-rate that changes then monetary policy would have little effect. It has an effect because low-interest rates allow investors to use leverage and high-interest rates discourage it. Through substitution (and leverage) all forms of investment are connected together.
In the post you link to on your website you say that using interest rates is distortionary. I agree, but it’s not anything like as distortionary as using changes in government spending. Government spending is, after all redistribution. You mention that households with variable rate loans are hurt by interest rate adjustments, certainly they are. But what about your preferred system? Households that happen to be rich at the time when the government are destroying money by increased taxation are out of luck. Those that happen to be rich when governments are creating it by running deficits are luckier. A cynical interpretation of the theory is that it is designed to redistribute from the rich to the poor, because the policy of tax changes it requires could only be implemented by cutting taxes for the poor during recession and raising them for the rich afterwards.
I think you confuse the idea that interest rate changes, or changes in the quantity of money don’t work with the idea that they don’t produce beneficial results when handled by Central Banks. I agree that they don’t produce good results, I doubt they ever will and I doubt the income policies that you propose will either.
On the PIH…
My point, like most supporters of the monetarists, was not to say that agents would be perfectly forward looking. The problem here is really: how can you tell how forward looking they will be? MMT and other sorts of income-based policies are supposedly simple and mechanical. When an income-flow falls the government cause another to rise in it’s place. But, once the uncertainty of expectations comes into play this no longer works. It matters how many people think a tax cut will be permanent and how many think it will be temporary. In fact, the same problem occurs as with interest rate or money supply policies, the expectations of the public have a strong effect on the outcomes.
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