Monetary Policy and the Great Recession

[Note: This was a talk I gave at a Mises (Canada) Circle at Toronto, in October 2011 — this was also my first official “lecture” ever. Since then, my views have changed somewhat (see “The Theory of Monetary Gluts“). Note also I refer to “money in circulation” — this is the wrong way to look at the demand for and supply of money. Nonetheless, I think I still agree with much of what I said then — for instance, I still think that business cycles characterized by malinvestment complicate straightforward monetary equilibrium analysis. I had already posted a video of the talk some time ago, but never the transcript. I’m making it available to save it and archive it, but also because I think I made an interesting point.]


The present financial crisis, which began in late 2007 and early 2008, has brought to the forefront discussion on monetary and fiscal policy.  For the first time in decades there has been forced upon various governments the responsibility to respond to a dramatic and exaggerated recession — now called the “Great Recession” — with monetary and fiscal stimulus.  Since 2008, the Great Recession has become even greater.  Despite over $1 trillion in fiscal stimulus between two presidencies, and trillions more in monetary packages, the United States finds itself stagnating in the same quagmire.  The European Union finds itself in an economic, and more importantly a currency, crisis that it had not taken into consideration when first creating its monetary union.  Even countries that escaped relatively unscathed, such as China, are finding themselves on the verge of another economic downfall, because their post-recession policies were designed perfectly to bring about another dramatic decline in industrial productivity — namely, fiduciary expansion.

The response to the financial crisis has been unprecedented, on an international scale.  Yet, the success of these interventions can certainly be brought into question.  This is especially true when one considers that even proponents of interventionism, such as professors Bradford DeLong and Paul Krugman, have acknowledged the lack of success of the to-date fiscal and monetary packages — even if these economists simply use this fact as evidence for the notion that what we need now is even greater stimulus.  Now that these efforts have ended in failure, the question is: what is the proper policy response to an important industrial fluctuation? Here, specifically, we will look at the role of monetary policy.

Economic consensus is firmly inflationary, and this consensus is not necessarily “mainstream”.  To what degree they support inflation depends, but it is still rather surprising that the supermajority of economists have argued in favor of expansionary fiscal policy.  One extreme of the “pro-inflation” spectrum can be represented by Paul Krugman, who argues that the Federal Reserve should increase the money base by several trillion dollars in an effort to create “inflationary expectations”, driving businessmen and consumers to spend money (operating under the assumption that deflationary expectations cause individuals to hold more money, rather than spend it).  The other extreme is occupied by quasi-monetarists, although even this part of the spectrum varies, who argue in favor of some form of expenditure targeting as a means of maintaining equilibrium between the demand for and supply of money.

We will consider these within an Austrian framework, meaning we approach monetary policy from an angle which recognizes the possibility of intertemporal discoordination through monetary distortions — that is, Austrian business cycle theory.  To put it shortly, an oversupply of money causes an increase in investment activity without the necessary increase in required savings, forcing businessmen to liquidate their investments when they realize that there are insufficient capital goods to complete their projects.  With this in mind, we can almost immediately discard the more extreme inflationary arguments, given that Austrians firmly believe that large increases in the supply of money will inevitably lead to industrial fluctuations.

The quasi-monetarist argument is a bit more difficult to deal with, given that it is not true that any increase in the supply of money can necessarily cause intertemporal discoordination.  For instance, an increase in fiduciary media — for the sake of simplicity: banknotes — in response to an increase in the demand for money — an increase in the quantity of money held — does not lead to intertemporal discoordination, given that this type of monetary movement simply leads to a stabilization of the supply of money in circulation.  That is, the quantity of money being bid towards prices is stabilized.  Furthermore, and perhaps most importantly, an increase in the quantity of banknotes resulting from an increase in the demand for money should not lead to changes in the rate of interest, meaning there should be no intertemporal impact outside of that which manifests from society’s time preference.

Given that the quasi-monetarist argument seems to be the most arguable, at least when analyzed under an Austrian lens, we will take some time to see why even slight inflation — to meet an increase in the demand for money — is not desirable during a deflationary episode.  It should be no surprise, that being said, that what I will argue in favor of today is a policy meant to eliminate all the government-imposed obstacles to price deflation, such as monetary stimulus and price controls.

More specifically, I suggest that we should adopt a system of free — or, unregulated — banking.  Very generally, this system is superior to bureaucratic — or socialized — systems of banking just as a result of the very nature of the latter: the entrepreneur will always be able to respond better to changes in the underlying economic factors than central planners (this, of course, being the crux of Friedrich Hayek’s “knowledge problem”).  I believe that such a system would be forced to accept general monetary deflation, due to different natural constrains imposed on note issuing banks.

An unimpeded monetary deflation will allow for the liquidation of malinvestment and the necessary readjustment of prices to reflect the true nature of the market and individual preferences.  In turn, this will allow for a quicker recovery, given that the general stabilization of prices (which correctly reflect the underlying market factors) will create an environment conducive to investment and wealth creation.  On the other hand, an inflationary policy — no matter how slight — can lead to a back and forth movement of prices which may prolong the period of price readjustment.

Finally, I will discuss real world examples of quasi-free banking (I say quasi, because no historic banking system has ever truly been free).  One of the best examples of a historic free banking system is that of Canada, prior to the introduction of centralized banking during the mid-1930s.  Historically, Canadian banking has suffered from less regulatory burdens — including the ability for branching —, and yet Canada has generally never suffered from bank failures as intensely as the United States, or other countries that have the alleged benefit of central banking.  Indeed, Canada’s banking system escaped relatively unscathed after both the initial credit contraction which led to the Great Depression and the most recent contraction in 2008.  In comparison, in both occasions, the American banking industry suffered from massive failures.

The Pitfalls of Quasi-Monetarism

I hope to approach the topic of quasi-monetarism with some modesty.  I am slightly embarrassed to bring up the topic in front of such an accomplished economist like Larry White, but on the other hand maybe I can bring forth a contrasting view — somewhere in between the “free bankers” and the “Rothbardians”.

What I call quasi-monetarism really refers to monetary disequilibrium theory, which was developed during the early 20th Century and brought to the forefront of monetary theory by economist such as Clark Warburton and Milton Friedman.  It has since then been adopted by contemporary economists such as Leland Yeager and most of the Austrians who make up the group that we can refer to as the “free bankers” — Larry White, George Selgin, Stephen Horwitz, Roger Garrison, et cetera.  To one degree or another it forms the basis of these economists’ views on monetary policy; namely, it serves as their justification for expansionary monetary policy.

It is easy to cringe when one hears the word “expansionary monetary policy”, largely because hard inflationists such as Krugman have given the term a horrible image that it probably does not deserve.  I reassure those skeptical of all paper money printing that there is merit to monetary disequilibrium theory!  Monetary disequilibrium theory is oftentimes automatically discarded by Austrian economists, because there is a lingering overgeneralization regarding monetary expansion, the pricing process, and industrial fluctuations.  This is not just an amateur generalization.  For instance, Jörg Guido Hülsmann, in “Towards a General Theory of Error Cycles” (The Quarterly Journal of Austrian Economics), basically argues that what he calls “error cycles” are, above all else, products of fractional reserve banking, bypassing entirely the quintessential aspect of the theory, which is intertemporal coordination.  I, despite being a free banker, am not a proponent of monetary disequilibrium theory, but I recognize that this is not the proper way of approaching monetary theory.

For the sake of having a simple starting point, let us assume that the supply of and demand for money is resting at equilibrium.  For one reason or another, there is an increase in the demand for money; that is, a greater quantity of money is being held — temporarily left unspent — by individuals.  Ceteris paribus, what this means is that the quantity of money in circulation — that is, being bid towards some good — falls.  In a world of perfect price flexibility, prices should then adjust to reflect the new quantity of money.  But, this perfect world does not represent reality.  Instead, prices are sticky — they take time to adjust —, and according to some economists this will cause a rupture in production.  The change in output prices will make some industries unprofitable, forcing them out of business.

The solution is to increase the supply of money.  In an aggregated sense, if the supply of money in circulation is stable, then there should be no wide price fluctuations capable of disrupting production.  The quasi-monetarist response to the recent recession, therefore, is an increase in the supply of money equal to the increase in the demand for money.  Since it is effectively impossible to distinguish what part of the monetary contraction originated from an increase in the demand for money, the next best solution is some type of income targeting.  For example, a common suggestion is to target GDP to offer some semblance of price stabilization.

I do not intend on critiquing any particular targeting scheme.  It should just be recognized that the ideal is to increase the supply of money by the same amount as the increase in the demand for money.  That some of these targeting plans overshoot this objective is well understood by Austrian “quasi-monetarists”.  That is why they consider these policies “second-best” alternatives; they are alternatives in a world of central and regulated banking.

As a free banker, I acknowledge how free banking theory may have stemmed from monetary disequilibrium theory.  In many respects it is similar.  An increase in the demand for money will decrease the volume of banknote clearings, allowing certain banks — those whose banknotes are being held — to increase the supply of outstanding fiduciary media (a.k.a. banknotes).  This branch of banking theory has been criticized for ignoring some capital fundamentals; namely, it is believed that all fiduciary expansion will distort the structure of production.  But, if savings are withheld consumption, then an increase in the demand for money should also be synonymous with a temporary increase in savings, which should then justify an increase in outstanding bank loans (the primary method of fiduciary expansion).  Banks are limited in just how many banknotes they can issue through loans by the rate of savings.  That is, as the demand for money falls the volume of clearings will rise, forcing banks to contract the amount of outstanding liabilities.

The reason I add this small caveat on free banking is because I want to emphasize that in no way is my critique of quasi-monetarism also a critique of free banking.  I firmly believe that one can agree with the Selgin/White banking model without having to accept the validity of monetary disequilibrium theory.

I will offer two criticisms of monetary disequilibrium theory.  First, I challenge the idea that maintaining monetary equilibrium will prevent entrepreneurial losses in the event of changes in consumer preference.  Second, monetary contractions have two major origins, where the second origin (an increase in the demand for money) is a byproduct of the first.  Increasing the supply of money may disturb the process of re-coordination made necessary by the other cause of monetary deflation — default and loan contraction.

Money disequilibrium theorists hold that in the event of an increase in the demand for money, if prices are forced to adjust downwards, there will be a period during which there will be a mismatch between output prices and input prices.  In other words, there will be a fall in profitability, due to a fall in aggregate demand for consumer goods.  An increase in the supply of money, equal to the rise in demand for money, will allegedly solve the problem by maintaining aggregate demand.

At the risk of sounding like an amateur Austrian, the issue here really is with aggregation.  There is a theoretical lacuna between the conclusions of monetary disequilibrium theorists and basic causal price theory.  The consumers who are increasing their demand for money will withdraw spending from certain industries.  It is not guaranteed that new money will be spent on these same industries.  What this means is that there will still be price fluctuations, and demand for certain consumer goods will still fall.  Businessmen will still have to adapt to changes in consumer preferences, whether or not the amount of money in circulation is maintained the same.  Some businesses will still be less profitable than they were before.

It is important to remember that these types of price fluctuations are natural occurrences in capitalist markets, whether the demand for money changes or not.  Consumer preferences change, meaning the amount of money being bid towards different goods will constantly change.  This suggests that prices will fluctuate in accordance with changes in preferences, and entrepreneurs will have to foresee and/or adapt to these changes.  That is the basic role of the entrepreneur, after all — to calculate present costs of input prices and compare these to the expected future prices of the products they plan to produce (and, as such, it is important to remember now that the future prices of the factors of production will be inputed from expected future demand for the end product; that is, the price of factors of production is largely dependent on expectations regarding future prices of outputs).

So, this brings to question whether or not the supposed “problem” of monetary disequilibrium is even a problem at all.  And, if changes in prices really were a problem then would this not be something inherent in the capitalist economy just by its very nature?  That is, if entrepreneurs cannot predict and/or adapt to changes in consumer preferences then how can they service their purpose as general market coordinators?  Simply put, monetary disequilibrium theory is not in line with the basic theory of entrepreneurship, let alone compatible with the Austrian view on economic coordination and Austrian price theory.

The second criticism of the quasi-monetarist policy prescription of limited monetary expansion is more relevant to the current financial crisis.  I hold that any attempt to increase the supply of money may interfere with the inevitable process of price readjustment after the initial financial collapse.  The major source of monetary deflation is not an increase in the demand for money.  An increase in the demand for money is a secondary product of the initial credit contraction, which is caused by the waves of defaults as entrepreneurs realize that their business projects are no longer as profitable as they had originally foreseen.  This sudden economic devolution into chaos will cause a rise in uncertainty, which may cause individuals to increase their demand for money.  Individuals may choose to hold greater quantities of money as a means of having currency on hand for short term purchases they may have to make in the future, but are currently unaware of.  For instance, a person may choose to hold $30 over a long period of time, instead of spending it on new clothes, only as a means of guaranteeing that he or she will have the sufficient funds to purchase important consumer products over a longer period of time than usual.

We are dealing with two separate forces: loan default and an increase in the demand for money.  I will sum up the criticism as follows: if banks are facing capital constraints from an increase in loan defaults (fall in expected profitability), how will they feel comfortable creating new loans to meet an increase in demand for money?  It seems to me that an increase in demand for money can only serve to cushion the problems of recessionary capital constraints.

This criticism can be translated into macroeconomic terms, as well.  If we assume Austrian theory of intertemporal discoordination (Austrian business cycle theory) to be true, then the problem originates with an oversupply of fiduciary expansion.  Austrians hold that fiduciary overexpansion through the loanable funds market will cause changes in the structure of production that assume an increase in the stock of capital goods, but without an actual increase in saved capital goods.  That is, the capital structure will widen and lengthen, but without the necessary capital goods to make this change viable.  What brings about the recession, therefore, is the realization — through the readjustment of prices — that there are insufficient capital goods to finish business projects catalyzed by fiduciary expansion.

If we further accept that an increase in the demand for money is an increase in savings and we place this within the framework of recessionary capital reallocation, I would argue that rather than give banks the basis for further loan extension, an increase in the demand for money will simply limit the necessary liquidation of investment.  That is, an increase in the demand for money will lessen the structural readjustment process of the recession, since it will increase the quantity of capital goods made available to entrepreneurs to bid towards the completion of their investments — capital goods that would have otherwise been unavailable (and, thus, a greater quantity of businesses would have necessarily defaulted).

To put it in simpler terms, an increase in the demand for money will cushion the volume of credit contraction originating from loan defaults, since it will allow some entrepreneurs to avoid defaulting altogether.  I see the macroeconomic implication of an increase in demand for money differently from the monetary disequilibrium theorist.  Where he or she may see an option for credit expansion, I see an opportunity to limit credit contraction.  That is, while the former is an active solution, I see a rise in the demand for money as a passive — in a policy sense — market effort to aid the readjustment, or recoordination, process.

To recap: I do not see monetary disequilibrium as a macroeconomic problem, and in the event of credit contraction I see a rise in the demand for money as a positive force that reduces the amount of malinvestment present in a particular market.

The Free Market Solution

While this may frustrate a great deal of persons who rather be given a policy to follow in order to solve the current financial crisis, my policy recommendation is a “do nothing” one.  And, by do nothing I do not mean that nobody should react — individuals react to changes all the time —, rather I am suggesting that the government should avoid, at all supposed costs, interfering with the ongoing market correction.

If we know that the market correction was caused by an intertemporal distortion caused by an overextension of fiduciary media — that is, malinvestment —, then we can deduce that the correction will have something to do with repairing the structure of production to rid it of malinvestment and realigning it in accordance with consumer preferences.  This repair is a matter of time, entrepreneurial effort, and price recoordination — all of these being interrelated, especially the relationship between the pricing process and the entrepreneur.

The issue of an economic correction, or what we might call “the recession”, is a complicated one that goes beyond monetary theory and policy recommendation.  It is a process which entails the reorganization of capital goods throughout the structure of production by means of economization of resources; this economization is controlled by the individual capitalist, or owner of capital, who uses owned resources as seen fit to reach given ends.  We know from the issue of economic calculation that the most efficient method of resource allocation is economization, and thus in regards to policy the only relevant question is how government can best avoid impeding the process of economization and in what ways government can aid the process of economization.  Different economists will answer this question differently, where most Austrians would probably agree that the role for government is very, very narrow (if existent at all).

As far as the pricing process and the supply of money are concerned, this issue was addressed earlier.  These kinds of industrial fluctuations are characterized by important credit contractions.  The initial contraction is caused by the nature of the cause of the recession — malinvestment.  Liquidation of debts, as businessmen walk away from bad investments, and loan contraction by part of banks (who struggle to raise capital to remain solvent) will cause a general contraction of the supply of fiduciary media (federal reserve notes in our case, or private banknotes in the case of a free banking industry).  An increase in uncertainty, as chaos takes over the structure of production, may lead to individuals holding more money than usual (i.e. a rise in the demand for money).  If we can say that this is synonymous to saving, then this should actually serve to help alleviate the issue of malinvestment by providing a greater supply of capital goods in an environment that is experiencing a shortage.

How bad this loan contraction would be is impossible to say.  Evidence provided in Jeffrey Friedman’s and Wladimir Kraus’ brilliant new book, Engineering the Financial Crisis, suggests that the severity of the monetary contraction which took place between 2007 and 2009 was actually a product of the web of regulations which made it much more difficult for banks to respond to the crisis.  Namely, mark-to-market enforcement caused banks to lose more money as a result of the downgrading of their owned mortgages and bonds than necessary, as much of the value of these assets was actually recuperated over the following two years.  Furthermore, minimum capital requirements, in conjunction with these regulations, caused banks to be legally insolvent, where they might not have been had banks not been so tightly regulated by the federal government.  In a struggle to be above capital minimums, banks which had originally maintained hefty capital cushions prior to the recession, were forced to contract outstanding loans to a much greater extent than otherwise, causing a more severe monetary deflation than necessary.

The extent of credit contraction, in any case, should be roughly equivalent to the degree of malinvestment which pervaded the market prior to collapse, minus whatever can be salvaged due to an increase in savings.  “Countercyclical” monetary policy, of any kind, can only serve to further confuse the process of the realignment of prices, or in other words, can only add to the chaos that is created by the liquidation of malinvestment.

All of this being said, it is important to remember — whether this is seen as market fundamentalism or not — that the exact response to a crisis of this sort depends largely on how the individual market agents respond.  Each person will respond to a changing environment in a different way.  This provides the subjective undertone to the process of economic recalibration.  This includes monetary movements and how individual banks respond to changes with regards to their assets and liabilities.  In effect, I fear that my explanation here falls victim to the same problems of oversimplification which are experienced by the majority of policy recommendations, and so emphasize that there is a very extensive grey area that should be further explored, or perhaps is not even predictable or calculable.

At the same time, though, I think it is reasonable to make the claim that the best thing we can do is look at policy recommendation or related theories that attempt to define the nature of the problem and compare them to reality.  I think when doing so, including when comparing monetary disequilibrium theory, we find that all these theories and policies are not fitting to deal with the problems of macroeconomic industrial fluctuations caused by intertemporal malinvestment.  They suffer from gross oversimplifications of the problem at hand.

Whether my own analysis of the “free market solution” does as well, in my opinion, is irrelevant given that I am not trying to push for any specific solution.  If I did have to highlight a solution then I would place faith in the thousands of solutions found by the individual market agents who will each respond to the crisis as they see fit.

Limited Free Banking in Canada

 In the two largest banking crisis in American history — the current one and the Great Depression—, Canada escaped relatively minimally scarred.  In both cases, Canada enjoyed a banking industry that in many ways was much less regulated than the American one.

One of my references for this lecture is a book by R. Craig McIvor called, Canadian Monetary Banking and Fiscal Development.  McIvor, from what I can gather from this book, is no free banker.  His book is largely a detailed history of the gradual regulation of the Canadian banking industry, from its birth to the end of the Second World War (including the foundation of Canada’s central banking system).  This type of narrative is also expressed in a book called Canadian Economic History, by W.T. Easterbrook and Hugh Aitken.

What is interesting, though, is that if you compare the evolution of the Canadian banking industry to that of the United States, you find that Canada introduced many regulations much later than the United States did.  So, relatively speaking, Canada’s financial industry has remained relatively freer, and this correlates with the fact that Canada has generally suffered less during international financial crises.  Friedman and Kraus argue, for instance, that the difference in regulatory webs between Canada and the United States allowed Canadian banks to take steps unavailable to their American counterparts.

Since my lecture is about monetary policy and not the history of free banking, and since Professor White has already provided a wonderful talk on that very subject, my intention here is not to review free banking in Canada in depth.  If you are looking for a detailed written account of Canadian free banking, Kevid Dowd provides such a history in his book, The Experience of Free Banking.    Rather, I would just like to emphasize the correlation between free banking in Canada and the differences in the size and severity of major international financial crises.  Canadian banks, in general, have been able to escape these crises without major bouts of illiquidity and bankruptcy.  That is, where American banks have been forced to dramatically contract the volume of outstanding loans, Canadian banks did not suffer from these type of capital constraints, or at least not to the same degree.

There may be important differences in terms of regulatory incentives, as well.  The regulations which governed the American financial sector acted as funnels, incentivizing banks to make heavy purchases of assets which were later deemed worthless as a result of the financial crisis.  It may be that Canadian banking did not suffer from the same incentives, thus giving Canadians a broader and more stable capital base, since their assets may have been more diversified.

Markets, Not Policy

Hayek once said something like, “To know where markets fail, you must know how markets work.”  I was asked to discuss monetary policy in our current financial crisis, but I think a more fruitful endeavor than discuss policy is to first study how the market works.  So far, by discussing policy we have only seen how these policies do not positively correspond to the nature of the market — in fact, as we have seen, monetary policy can only impede the process by which the market can aid recovery.

It is possible, I think, to discover the processes that make up the market and then pinpoint how government institutions can positively contribute to the market process.  But, as far as I have seen, there really has been little effort to do as much.  Rather, economists and policy makers have instead preferred to work off their limited understanding of market dynamics and legislate in such a way that it could only help in their own limited view of the economy.  Regulations, which were already originally bad, were joined by more regulations, and bad was compounded upon bad.  Today, we live in a market that is so tightly regulated by such a ridiculously expansive web of laws that these rules actually contradict each other, and they do so in such a way that it dramatically limits how a bank can act.  This bureaucratic reality, in the United States, led to the worse financial crisis since the Second World War.

If I leave room open for the possibility of positive policy, then am I conceding that there may be a countercyclical policy that could possibly aid the market in achieving recovery?  I certainly concede that I do not know the nature of the market well enough to answer that question conclusively.  But, this concession alone provides the strongest basis in favor of market fundamentalism.  Markets are complex; the greater the division of labor, the more complex the market.  The more complex the market the more pervasive the effects of single changes, and the more difficult it is to know the consequences of a policy.

My point is that we may be at a point where it is impossible to accurately know exactly a policy can distort the market, negatively or positively.  This is a type of knowledge problem.  Nobody may have the sufficient knowledge to design a policy that can be delegated by a central authority that will not produce a negative distortion.  This problem is certainly an argument in favor of free markets, and the evidence so far has proven — in my opinion — that this knowledge problem has caused that banking regulation has led to the creation of an intolerable liability within the financial sector.  That is, instead of helping avoid a major financial crisis, regulation has instead led to a deepening of the crisis.

Just the same, monetary policy so far has caused a worsening of economic conditions, rather than aided recovery.  The market may be so complex that there can be no simple monetary policy capable of positively influencing the economy.  Instead, we should allow the division of labor to operate in such a way that individuals can react to changing conditions as they see fit, bringing about a macroeconomic recovery in the aggregate.  A free banking industry would do just that, as far as the financial sector is concerned.

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