The Key Problem with Friedman’s Fisherine Approach Is the Same Orthodox Separation of the Micro and Macro Spheres

The third major feature of the New Deal program was proto-Keynesian: the planning of the “macro” sphere by the government in order to iron out the business cycle. In his approach to the entire area of money and the business cycle—an area on which unfortunately Friedman has concentrated most of his efforts—Friedman harks back not only to the Chicagoans, but, like them, to Yale economist Irving Fisher, who was the Establishment economist from the 1900s through the 1920s. Friedman, indeed, has openly hailed Fisher as the “greatest economist of the twentieth century,” and when one reads Friedman’s writings, one often gets the impression of reading Fisher all over again, dressed up, of course, in a good deal more mathematical and statistical mumbo-jumbo. Economists and the press, for example, have been hailing Friedman’s recent “discovery” that interest rates tend to rise as prices rise, adding an inflation premium to keep the “real” rate of interest the same; this ignores the fact that Fisher had pointed this out at the turn of the twentieth century. 

But the key problem with Friedman’s Fisherine approach is the same orthodox separation of the micro and macro spheres that played havoc with his views on taxation. For Fisher believed, again, that on the one hand there is a world of individual prices determined by supply and demand, but on the other hand there is an aggregate “price level” determined by the supply of money and its velocity of turnover, and never the twain do meet. The aggregate, macro, sphere is supposed to be the fit subject of government planning and manipulation, again supposedly without affecting or interfering with the micro area of individual prices.

—Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 45-46.

Friedman and Schwartz’s Case That the Demand for Money (the Inverse of Velocity) Is Constant Is Statistical Legerdemain (a Sleight of Hand)

For many years I [Joseph T. Salerno]—and other Austrians—have had to endure charges by monetarists that Murray Rothbard fudged the data to increase monetary growth rates during the 1920s in order to portray it as an inflationary decade. As I argued in an exchange with eminent monetary historian Richard Timberlake these allegations are baseless. So, now it is with delicious irony that I draw your attention to an explosive article by three econometricians thoroughly debunking the empirical claim made by Milton Friedman and Anna Schwartz that the velocity of money in the U.S. has exhibited long-run stability for more than a century leading up to 1975. 

Neil Ericsson, David Hendry, and Stedman Hood argue that dubious “data adjustment” in Friedman and Schwartz’s empirical models “dramatically reduced apparent movement of the velocity of circulation of money and . . . adversely affected the constancy and fit of his estimated money demand models.” In other words, Friedman and Schwartz’s empirical case that the demand for money (the inverse of velocity) is constant, which Friedman and Schwartz painstakingly elaborated in three statistical tomes published from 1963 to 1982 and which is the linchpin of monetarism, has been exposed as statistical legerdemain. 

Friedman and Schwartz adjusted the raw data to account for: 1. the sudden onset of rapid developments of financial instruments and institutions in the U.S. economy compared to the U.K. economy; and 2. short-run fluctuations in velocity associated with business cycles. In adjusting for “changing financial sophistication,” Ericsson et al. point out, Friedman and Schwartz added a linear trend of 2.5% on money supply observations prior to 1903, but made no trend adjustment at all to the data after that year. In the process, they “adjusted” the money stock for 1867 from its raw or unadjusted value of $1.28 billion to $3.15 billion. This is a phantom increase of 246% on the observed money stock! The result of this trend adjustment was to substantially suppress the effect of the precipitous decline in observed velocity of more than 50% from the early 1870s to 1903 on its variability over the entire period studied (1867-1975). Thus although the adjustment applies to only 30% of the period studied, it accounts for almost 75% of the total variance of velocity.

—Joseph T. Salerno, “Milton Friedman Debunked—by Econometricians,” Mises Wire, entry posted May 12, 2017, https://mises.org/wire/milton-friedman-debunked-econometricians (accessed April 16, 2021).

The Parallels between the Myth of the Laissez-Faire Hoover and the Myth of the Do-Nothing Fed Are Striking

In addition to the myth of the laissez-faire Herbert Hoover, another popular theory of the Great Depression blames the do-nothing Federal Reserve. Ironically, this interpretation comes, not from Big Government critics of the free market, but instead from none other than Milton Friedman and his monetarist followers. Just as modern-day Keynesians urge the government to “avoid the mistakes of Hoover” by running up massive deficits, so too do modern monetarists urge the Fed to “avoid the mistakes of the Depression” by injecting massive amounts of reserves into the banking system. 

The parallels between the myth of the laissez-faire Hoover and the myth of the do-nothing Fed are striking. Just as Hoover engaged in unprecedented “stimulus” through his fiscal policies, so too did the Fed—starting immediately after the stock market crash in 1929—engage in unprecedented “easy money” policies. Because the massive budget deficits eventually forced Hoover to reverse course and raise taxes (in 1932), modern Keynesians say Hoover didn’t borrow-and-spend enough. Similarly, because a gold outflow from the country eventually forced the Fed to reverse course and tighten the money supply (in late 1931), the monetarists say the Fed didn’t inflate enough. But in both cases, the question remains: If budget deficits and cheap money were the right medicine, why was the Depression still getting worse, two years into these unprecedented fiscal and monetary remedies?

—Robert P. Murphy, “Did the Tightwad Fed’s Deflation Cause the Great Depression?” in The Politically Incorrect Guide to the Great Depression and the New Deal (Washington, DC: Regnery Publishing, 2009), 63-64.

New Keynesian Views on Monetary Theory and Policy Are More Fallacious Than Those of Their Predecessors

The essential fallacy of John Maynard Keynes and his early disciples was to cultivate the monetary equivalent of alchemy. They believed that paper money was a suitable means to alleviate the fundamental economic problem of scarcity. The printing press was, at any rate under certain plausible conditions of duress, a substitute for hard work and savings and cutting prices. 

The self-styled new Keynesians have not at all abandoned this fallacy and they therefore do not differ in any essential respect from the old Keynesians, in spite of the pains they take to distinguish themselves from the latter. The new Keynesian recommendation for monetary policy is to “stabilize the growth of aggregate demand.” In plain language this means that the monetary authorities should never stop flooding the economy with paper money. Recognizably, this is the core tenet of the old Keynesian monetary program, which in itself had been nothing but even older fallacies clothed in the new language of aggregate analysis. 

In many respects, new Keynesian views on monetary theory and policy seem to be even more fallacious than those of their predecessors. Whereas Keynes and his immediate followers were still trained in the old-fashioned art of economic reasoning, the new Keynesians are macro economic purebreds. Their expertise lies more or less exclusively in the field of modeling. As with the macroeconomics profession in general, they are devoted to a positivistic methodology, putting all their energies into modeling quantitative relationships among things that are the result of human action, rather than into the analysis of human action itself. Not surprisingly, therefore, their “science” of the economy resembles a hotchpotch of educated guesswork, conventions, and fictions, all designed to make the problems under consideration amenable to mathematical treatment. 

—Jörg Guido Hülsmann, “New Keynesian Monetary Views: A Comment,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 73.

The Textbook Rendition of the Short-Run Phillips Curve Dynamics Clashes with the Empirical Record and with a Fundamental Proposition of Monetarism

Textbook writers and even many self-identified monetarists have taken this short-run/long-run Phillips curve analysis to be the monetarists’ account of the market mechanisms that cause a money-induced boom to go bust. Much more plausibly, however, Friedman’s presidential address was intended only as immanent criticism of the views held by his Keynesian-oriented contemporaries. Many saw the Keynes-inspired downward-sloping Phillips curve as an enduring trade-off between inflation and unemployment, a virtual menu of policy choice for left-leaning politicians willing to put up with inflation in order to reduce unemployment and for right-leaning politicians willing to put up with unemployment in order to reduce inflation. Friedman’s message was simply that there is no long-run trade-off. 

The common textbook rendition of the short-run Phillips curve dynamics actually clashes both with the empirical record and with a fundamental proposition of monetarism. The low unemployment rate during the boom depends on wage rates lagging behind rising output prices. This sequence would mean that real wage rates are relatively low during the boom. But the notion of low real wages during credit-induced booms has no empirical support. (In the Austrian view, the artificially cheap credit increases investment, increases the demand for labor, and hence increases the real wage rate. In fact, the higher real wages are in large part responsible for the political popularity of credit-induced booms). 

Not long after Friedman offered his criticism of the Phillips curve as a menu of choice, he set out ten fundamental propositions of monetarism, which included the proposition that a monetary expansion causes quantities (output and, as a virtual prerequisite, employment) to increase first and prices only later. With this sequence, of course, it cannot be the rising prices that, being differentially perceived by employers and employees, are responsible for increased employment and output. Friedman actually finessed the issue of “quantities then prices” versus “prices then quantities” in his presidential address, portraying the latter as an extra boost during a later phase of the adjustment process. But it was exclusively the “prices then quantities” sequence that became the standard textbook version, formalized by Robert E. Lucas Jr. as a monetary misperception theory of the business cycle. In any case, the “quantities then prices” understanding, which Friedman favored, is evidently not strong enough to show up in his highly aggregative monetarist framework as an empirically verifiable boom-bust sequence.

—Roger W. Garrison, review of Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, by Kevin Dowd and Martin Hutchinson, The Independent Review: A Journal of Political Economy 16, no. 3 (Winter 2011/2012): 444-445.

Irresponsible Monetary Policy Eventually Leads to an Increase in the Natural Rate of Unemployment

As Bellante and Garrison (1988) remind us, Friedman acknowledges that irresponsible monetary policy would eventually lead to an increase in the natural rate of unemployment. Two of Friedman’s papers (1976 and 1977) suggested the potential existence of a positively sloped Phillips curve. But in neither case did Friedman reconsider his model of dynamic monetary theory in light of his empirical work. 

In his Nobel lecture, Friedman acknowledged that additional research was needed to resolve the inconsistency between the monetarist Phillips curve and empirical data. He anticipated that this “third stage” of the research into the relationship between inflation and unemployment would only be successful if a way was found to incorporate political factors:

In recent years, higher inflation has often been accompanied by higher not lower unemployment, especially for periods of several years in length. A simple statistical Phillips curve for such periods seems to be positively sloped, not vertical. The third stage is directed at accommodating this apparent empirical phenomenon. To do so, I suspect that it will have to include in the analysis the interdependence of economic experience and political developments. It will have to treat at least some political phenomena not as independent variables—as exogenous variables in econometric jargon—but as themselves determined by economic events—as endogenous variables [. . .]. The third stage will, I believe, be greatly influenced by a third major development—the application of economic analysis to political behavior, a field in which pioneering work has also been done by Stigler and Becker as well as by Kenneth Arrow, Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock, and others. (1977, p. 470)

In my doctoral thesis (Ravier, 2010), I called this “Friedman’s dilemma” because Friedman observed an empirical reality his own analytical framework was unable to explain. Friedman observes a positively sloped Phillips curve and a long-term effect of monetary stimulus which is not neutral in real terms. Both are inconsistent with his own theories. Instead he provides evidence confirming the work of Robert Lucas (1973) and, more recently, William Niskanen (2002). Robert Mulligan (2011) has demonstrated the connection between Niskanen’s article and Austrian business cycle theory.

—Adrián O. Ravier, “Dynamic Monetary Theory and the Phillips Curve with a Positive Slope,” Quarterly Journal of Austrian Economics 16, no. 2 (Summer 2013): 172-173.

The Method Used to Develop the Phillips Curve Is More Akin to That of the German Historical School

The Phillips curve is named after the British economist A. W. Phillips (1958), who in a pathbreaking article investigated the statistical relationship in the UK between the annual rate of change of money wages and the annual rate of unemployment. Later versions of the Phillips curve examined the relationship between unemployment or the rate of growth of output and, alternatively, the rate of change of product prices, and the deviation between actual and ‘expected’ inflation. 

Inasmuch as the Phillips curve is an important component of mainstream economics, its development remains a curious paradox. Logical positivism is the conventional methodology of the neoclassical mainstream and this methodological doctrine has been severely criticized by economists working within the Austrian methodological perspective. Logical positivism involves the construction of theory that is tested by empirical evidence. The resulting empirical evidence may lead to modification of the theory and further testing, but the initial theory construction always precedes empirical testing. The Phillips curve developed purely as an empirical relationship with only ad hoc theoretical rationalizations provided. Only later were attempts made to develop a theory that would ‘explain’ the statistical relationship. This method is more akin to that of the German historical school, of which criticism by the Austrian school has been much more severe. The series of currently recognized policy errors that followed from attempts to exploit the Phillips curve serves as an excellent but unfortunate example of the problems associated with ‘letting the facts speak for themselves.’

—Don Bellante, “The Phillips Curve,” in The Elgar Companion to Austrian Economics, ed. Peter J. Boettke (Aldershot, UK: Edward Elgar Publishing, 1994), 372.

The Critical Difference between New Classicism and Austrianism Lies in Differing Treatments of the KNOWLEDGE PROBLEM

The New Classicists accept the Monetarist propositions about the long run and argue that the assumption of “rational expectations” allow those propositions to apply to the short run as well. In effect, the New Classicists deny the significance of Hayek’s distinction between two kinds of knowledge. Market participants behave “as if” they actually know the structure of the economy. They react to monetary expansions in ways that compensate for price and interest-rate distortions. So long as expectations about future price and interest-rate movements are not systematically in error, there will be no intertemporal discoordination, and no discoordination of any other kind that can be attributed to the monetary expansion. In this view, a Hayekian trade cycle anticipated is a Hayekian trade cycle avoided. 

The rational-expectations argument is nothing new to Austrian theory. In fact, Mises (1953) recognized the kernel of truth in the argument long before the appearance of John Muth’s (1961) classic article. He warned the advocates of inflationary finance against ignoring Lincoln’s dictum: You can’t fool all the people all the time. In the early 1940s Ludwig Lachmann (1977) called the Austrian theory into question on the basis of what was, in effect, a rational-expectations argument. The rise of the New Classicism in recent years has refocused attention on the role of expectations in trade cycle theory. Without doubt, the course of the trade cycle is influenced in a fundamental way by the expectations of market participants. But the idea of rational expectations is not quite the show stopper that the New Classicists believe it to be. Again, the critical difference between New Classicism and Austrianism lies in differing treatments of the knowledge problem. 

It is peculiar for economists to assume that market participants know, or behave “as if” they know, the structure of the economy. After all, economists have had disagreements among themselves for more than 200 years about how the economic system works. Some believe that the economy works in the manner envisioned by Keynes or by his many interpreters, some believe that the economy is more  accurately depicted by the Classical model, and some believe that the economic relationships identified by the Austrians are essential to the understanding of the economy’s structure. There are important differences even within each of these three theoretical frameworks, and there exist still other, more radical alternatives such as Marxism and modern Institutionalism. 

It would be an amazing feat for market participants either individually or collectively to single out not only the correct theoretical framework but also the parametric values that are currently applicable. And if they actually performed this feat (or behaved “as if” they had performed it), the question of just how they did it would be the most challenging question the economics profession has yet faced.

—Roger W. Garrison, “Hayekian Trade Cycle Theory: A Reappraisal,” Cato Journal 6, no. 2 (Fall 1986): 443-444.

Austrian Business Cycle Theory Incorporates Aspects of a Number of Alternative Theories, e.g., Classical, Phillips Curve etc.

At first, the Austrian theory of business cycles appears very different from other main schools of macroeconomic thought. Yet a comparison shows that it actually incorporates a number of features of alternative theories. Garrison (2001; Ch. 12) provides a useful—if stylized—overview, summarized in Figure 1. 

In the Classical view, the economy operates on the production possibilities frontier (ppf), and agents have a choice between consumption and investment, which therefore tend to move in opposite directions. Over time, higher investment implies faster growth, which leads to a ppf that moves up and to the right more quickly. A choice for higher immediate consumption tends to slow growth. In the Classical view, there is no room for short-term fluctuations, only secular growth. 

In the Keynesian view, the economy is generally not on the ppf. Left to its own devices, the economy suffers from a chronic lack of demand, leaving it in a continuous state of semi-depression. Expansionary economic policies can increase demand and move the economy towards the ppf. Note that investment and consumption generally move together, in response to increases and decreases in aggregate demand. 

Real business cycle theories see all fluctuations as caused by real shocks. Markets are assumed always to be in equilibrium, and there are no departures from the ppf. Business-cycle related movements that appear to take the economy off the original ppf are considered to be the result of movements of the ppf itself, driven mostly by stocks to productivity.

Theories that incorporate a Phillips curve postulate a (temporary) tradeoff between inflation and unemployment. An unanticipated monetary expansion will allow the economy to operate beyond the ppf, but only temporarily, as long as it takes prices to adjust. The policy-induced boom is unsustainable; eventually, prices will rise and the economy will settle back on the ppf. Expectations-augmented versions of the theory require a continuously accelerating rate of inflation to sustain production beyond the ppf. 

Austrian business cycle theory incorporates aspects of a number of these alternatives: it draws heavily on classical theory by stressing the preference-based tradeoff between consumption and investment, but acknowledges the potential for the economy to operate beyond the ppf, as in Phillips-curve based theories. But in Austrian theory, the economy does not simply return to the ppf after the boom. The initial credit-induced changes in investment were not based in preferences and thus prompted a mismatch between the structure of production and planned future consumption. This triggers a change in intertemporal relative prices, raising the interest rate, which triggers a recession. Attempts by the monetary authorities to stave off recession are doomed to failure; the economy needs time and unfettered interest-rate signals to readjust its capital base to the structure of demand. 

—Stefan Erik Oppers, “The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy?” (working paper no. 02/2, International Monetary Fund, 2002), 14-15, https://www.imf.org/external/pubs/ft/wp/2002/wp0202.pdf.

Something Had Gone Wrong with the Steering Mechanism of Federal Reserve Policy and It Behooves Us to Know Why

The reason why all this deserves attention is that we now know that the Titanic of the US financial system in 1923 was even then on course for the iceberg of 1929. Something had gone wrong with the steering mechanism of Federal Reserve policy and it behooves us to know why. At several points in his review of US monetary policy in the early 1920s (chapter 2, this volume), Hayek raised warning flags, particularly in section six, which points to the lack of a coherent theoretical foundation. 

What went wrong? The Reserve Board was no longer able to use changes in the reserve ratio as the steering mechanism. “Under the present conditions, with gold embargoes in force in most foreign countries and the United States practically the only free gold market of the world, the movement of gold to this country does not reflect the relative position of the money markets nor does the movement give rise to corrective influences, working through exchanges, money rates, and price levels, which tend to reverse the flow. The significance which movements in the reserve ratios formerly possessed rested upon the fact that they were the visible indicators of the operation of the nicely adjusted mechanism of international finance. With this mechanism now inoperative, the ratios have lost much of their value as administrative guides. It has therefore been necessary for banking administration even in those countries that have been most successful in maintaining a connection with the gold standard to develop or devise other working bases.”

—Stephen Kresge, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, by F. A. Hayek (Indianapolis: Liberty Fund, 1999), 22.

Surprisingly, Hayek in 1937 Expressed a Preference for an International Central Bank over International Free Banking

In the choice between the two routes to a truly international monetary system, Hayek in 1937 expressed a preference for an international central bank over international free banking. This is surprising given the outlook on economic policy for which he was well known, a classical liberal appreciation for the profound limitations of government activism. 

The language Hayek used is even more surprising in light of his more recent (1973, 1988) critiques of “constructivist rationalism” in social thought. In the 1937 lectures, he spoke of “the ideal” of “a rationally regulated world monetary system,” and commented that “a really rational monetary policy could be carried out only by an international monetary authority, or at any rate by the closest cooperation of the national authorities and with the common aim of making the circulation of each country behave as nearly as possible as if it were part of an intelligently regulated international system.”

—Lawrence H. White, “Monetary Nationalism Reconsidered,” in Money and the Nation State: The Financial Revolution, Government and the World Monetary System, ed. Kevin Dowd and Richard H. Timberlake Jr. (New Brunswick, NJ: Transaction Publishers, 1998), 379.

Hayek’s Constancy of Nominal Spending Rule (Keep MV Constant) Made Him Doubt the Merits of the Gold Standard and Free Banking

Hayek noted that a hypothetical gold monetary system in which the money stock consisted exclusively of gold coins (without bank-issued money) would poorly approximate his norm because the stock of monetary gold would not adjust promptly to offset changes in velocity. Gold accumulated slowly from additional mining following a rise in the relative price of gold. Nor would a system with bank-issued money approximate it well, he thought, unless a central bank existed to promptly offset any changes in the volume of bank-issued money not warranted by velocity changes. Thus Hayek was more ambivalent than Mises regarding the merits of the gold standard and free banking. 

—Lawrence H. White, “The Roaring Twenties and Austrian Business Cycle Theory,” in The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 83-84.

Hayek Wants NOT a Constant Money Supply BUT a Neutral Money Supply Insuring that There Will Be NO Monetary Causes of Price Changes

The Mises-Hayek business cycle theory led Hayek to the conclusion that intertemporal coordination is best maintained by constancy of nominal spending or “the total money stream.” In terms of the variables of Irving Fisher’s equation of exchange (MV=PQ), nominal spending is the money stock times its velocity of circulation, MV. In Prices and Production Hayek recommended that to keep MV constant the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V. The price level P should be allowed to fall with growth in real income Q. As Hansen summarized the prescription:

The supply of money should, therefore, be kept constant, except for such increases or decreases as may be necessary to offset . . . changes in the velocity of circulation . . . Hayek wants, therefore, not a constant money supply, but a neutral money supply — one which will insure that there will be no monetary causes of price changes.

—Lawrence H. White, “The Roaring Twenties and Austrian Business Cycle Theory,” in The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 83.

For Supply-Siders, Gold’s Market Value Is a Sensitive Indicator of Impending Changes in the Overall Price Level

Under the supply-siders’ preferred alternative, the Fed is obliged to target the price of a commodity, say gold, whose market value is believed to be a sensitive indicator of impending changes in the overall price level. For example, if the target price of gold is established at $400 per ounce and it starts to exhibit a tendency to decline below this level on the open market, it indicates to the Fed that there is a developing shortage of money and spending, which threatens to reduce prices throughout the economy. By purchasing gold or even Treasury securities from the public in exchange for newly-created dollars until the price of gold returns to its target level, the Fed automatically remedies the monetary shortage and thereby offsets the tendency of the price level to decline. On the other hand, a surfeit of cash balances in the economy [surfeit means an amount that is too large, or is more than is needed]   is indicated by upward pressure on the market price of gold. The Fed relieves this pressure by selling gold or securities to the public and, in the process, absorbs and extinguishes the excess dollars before the general price level can be driven up. 

—Joseph T. Salerno, “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot,” in Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), 27. 

The Supply-Side Gold Price Rule Is Akin to the Keynesian Formula; Monetarists Also Share a Kinship to Supply-Siders Since Both Seek Price Stability

The school of supply-siders who favor a gold standard is led by eminent writers and politicians, such as Robert Mundell, Arthur Laffer, Jude Wanniski, and Congressman Jack Kemp. They all want the Federal Reserve to follow a “price rule,” that is, to stabilize the value of the dollar by holding the price of gold at a certain point or within a certain range. 

The Federal Reserve is to engage in open-market operations or adjust the discount rate to maintain the price of gold at a certain point or within a certain range. With a price rule of $300 to $400 an ounce, if the price approached $400, the Fed would contract its total volume of credit to exert downward pressures on the price of gold; when the price fell to $300, the Fed would expand credit and send the price of gold back up again. By stabilizing the gold price through credit expansion or contraction, all other prices would be stabilized in the end. 

The supply-side scheme of price rules for gold is a derivation of Irving Fisher’s scheme for stabilizing the purchasing power of money by way of a “commodity standard.” However, while Professor Fisher (1867-1947) wished to retain redemption in gold, although no longer at a fixed weight of gold, most supply-siders have no such immediate intention. They would merely observe the price of gold, and then manage Federal Reserve credit in reaction to price changes. 

In a sense, the gold price rule is akin to the Keynesian formula of full employment and economic growth through contra-cyclical credit manipulation; however, Keynesian managers expand and contract always with an eye on several indexes, especially those of employment and economic growth. The task of supply-siders is much simpler; they merely need to watch the price of gold. 

The monetarists may notice a kinship to supply-siders despite their heated debates. Both build their structures on the foundation of a money monopoly and legal tender force; both would try to stabilize economic life through currency adjustments. Monetarists seek stability by means of a steady rate of currency issue; supply-siders prefer a price rule that calls for prompt adjustments in the stock of money. Both seek price stability. 

Supply-siders seem to be alone in their great naïveté about the Federal Reserve System’s ability to hold the price of gold at any level. In 1934, after just ten years of Federal Reserve manipulation, the dollar was devalued from 1/20.67 of an ounce of gold to 1/35, which raised the price of gold from $20.67 an ounce to $35.00. The dollar has suffered two formal devaluations and countless “floating” devaluations since then, raising the price of gold from $35 per ounce to more than $300 today. 

—Hans F. Sennholz, Money and Freedom (Cedar Falls, IA: Center for Futures Education, 1985), 43-44.

Regulatory Obfuscation and Accounting Gimmickry Have Been the Preferred Approaches of Central Banking with Respect to Capital Inadequacy in Banking

Today [June 1990], many large banks are operating with capital ratios below 5 percent. But even these ratios overstate capital adequacy in the banking system because banks do not adjust the value of their loan portfolios to reflect market values. The resort to accounting gimmickry to mask weakness in the banking system is not new, although it is accelerated when that weakness becomes widespread. One economist noted that “indeed, the use of book value accounting in banking was promoted by regulators in the 1930s to deliberately mask the banks’ poor financial condition . . . . It appears that opposition to market value accounting comes less from banks themselves than from the regulators.” The practical difficulties of marking loans to market value are starting to be overcome with the rise of a secondary market for bank loans. But this market is simultaneously providing evidence of how far bank loan values are overstated. For example, most banks have written down loans to Latin American countries by 25 percent, carrying them in effect at 75 cents on the dollar. Yet the secondary market for such debt shows its market value to be approximately 25 cents (as of late 1989) and declining rapidly, from 65 cents only 1 year earlier. Many money center banks would wipe out their equity cushion by recognizing the market value of these loans alone. The market for bank stocks has reflected this fact better than bank accountants and regulators (who should know better), as investors discount bank stock prices in relation to book values. Capital adequacy also has been overstated to the extent that banks have moved a significant amount of their liabilities off the balance sheet in the form of credit commitments, interest rate swaps, and standby letters of credit. The most important point is that regulatory obfuscation and accounting gimmickry, not genuine reform, have been the preferred approaches of central banking with respect to capital inadequacy in banking. 

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 65-66.

A Government-Guaranteed Deposit System Artificially Lowers the Cost of Debt Financing for Banks and Increases the Proportion of Debt in the Balance Sheet of the Banking System

Central banking’s provision of deposit insurance with artificial ceilings on interest rates paid on those deposits also diminishes capital adequacy in the banking system. Finance theory demonstrates that firms (banks included) will choose a proportion of debt and equity in their capital structure that minimizes the blended cost of capital. But a government-guaranteed deposit system that is backed by a central banking institution with a monopoly on fiat base money creation, lender-of-last-resort powers, and the right to limit deposit rates, artificially lowers the cost of debt financing for banks and increases the proportion of debt (and lowers the proportion of capital) in the balance sheet of the banking system. Banking is the only industry in which the government agrees to guarantee the short-term liabilities of every participant. It is an arrangement that naturally encourages the use of debt (deposits) instead of capital to finance asset growth. There is a substitution of “public capital” (government-insured deposits) for “private capital” (equity that would have been employed in the absence of government-guaranteed deposits). The imposition of corporate taxation and the tax-deductibility of interest expense (but not dividends) also reflects government intervention and further promotes leveraging and capital inadequacy in the banking industry. Although the banking industry shares with other industries this tax-driven motivation to employ more debt than capital, corporate taxation and tax-deductible interest nonetheless remain nonmarket factors bearing on the decision to leverage. They would not be operative in a free market.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 30.

The Lender-of-Last-Resort Function Inherent in Central Banking Encourages Capital Inadequacy in the Banking System

The lender-of-last-resort function inherent in central banking also encourages capital inadequacy in the banking system. The central bank agrees to lend reserves to illiquid banks even if they also are insolvent. The lender of last resort is not concerned with the cause of the illiquidity, even if it arises due to depositors anticipating a bank’s insolvency. The illiquidity, not the insolvency, is seen as the problem requiring a solution. When illiquidity arising from the threat of bank insolvency is remedied by such nonmarket “lending” as the central bank provides, and when such lending is promised unconditionally as a matter of policy, capital adequacy is further undermined, or at least not rectified. 

The expectation that central bank lending is unconditional and unlimited derives from the fact that it is not actually lending at all. Last resort lending by a central bank does not have its source in some existing supply of capital or reserves. In the marketplace, “lending” consists of the transfer of existing purchasing power from one party to another, in which one foregoes its use over time in return for interest. But a central bank committed to rectifying banking system liquidity does not lend or transfer existing reserves. It “creates” reserves, not out of real resources or capital but solely by virtue of its monopoly power over fiat base money creation. This monopoly power sanctions risky banking and promotes banking system leverage through enhanced inflating capacity. Advocates of central banking believe that such a reserve base is beneficial because it is nearly costless. But the creation of fiat reserves costs the banking system its long-term strength.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 29-30.

The Two Rules Regulating Socialism’s Capital Structure Can Be Viewed Profitably Alongside their Free-Market Counterparts

The controversy surrounding socialism does not so much concern the above; rather, it concerns production and how socialism can have accurate factor pricing without competition. Lange here introduces several rules that are intended to replace and improve upon capitalist production. The first rule is to have all producers equalize the ratios of marginal productivity to their prices, for all the factors of production (e.g.,  MP_a ÷ P_a = MP_b ÷ P_b = MP_n ÷ P_n ).

The second rule, to be used in tandem with the above, is to price production equal to marginal cost, a principle first recommended by Fred Taylor and readily adopted by Lange. This marginal cost principle, the welfare ideal of neoclassical economics, is addressed not only to the singular firms but to the industries as well.

The above two rules regulating socialism’s capital structure can be viewed profitably alongside their free-market counterparts. Profit maximization under capitalism is replaced by producing at minimum average cost. Free entry/exit and the optimum size of plant in the market order are likewise duplicated by the same rule. The second rule, of setting price to marginal cost, conforms to the “pure and perfect competition” ideal under capitalism. Setting marginal benefits to marginal costs is seen as maximizing welfare (the Pareto optimality) for society. In all, the rules fully cover the economics of production, “determin[ing] the combination of factors of production and the scale of output” while also maximizing welfare. 

—Robert Bradley Jr., “Market Socialism: A Subjectivist Evaluation,” Journal of Libertarian Studies 5, no. 1 (Winter 1981): 24-25.

Rampant Inflation Destroys the Capital Markets that Sustain Economic Production; Capitalists and Businessmen Learn to Hedge for Financial Survival

The Keynesian commitment to expansionary policies is a commitment to inflation that does not promote full employment. It does not achieve the “miracle . . . of turning a stone into bread,” but generates the business cycle with periods of high unemployment. Continued application of the Keynesian recipe must finally lead to the complete breakdown of the monetary system and to mass unemployment. 

Rampant inflation destroys the capital markets that sustain economic production. The lenders, who sustain staggering losses from currency depreciation, are unable to grant new loans to finance business. Even if some loan funds should survive the destruction, lenders shy away from monetary contracts for  any length of time. Business capital, especially long-term loan capital, becomes very scarce, which causes economic stagnation and decline. To salvage their shrinking wealth, capitalists learn to hedge for financial survival; they invest in durable goods that are expected to remain unaffected by the inflation and depreciation. They buy real estate, objects of art, gold, silver, jewelry, rare books, coins, stamps, and antique grandfather clocks. Surely, this redirection of capital promotes the industries that provide the desired hedge objects. But it also causes other industries to contract. It creates employment opportunities in the former and releases labor in the latter. As the hedge industries are very capital-intensive, working with relatively little labor, and the contracting industries are rather labor-intensive, with a great number of workers, the readjustment entails rising unemployment. Of course, the readjustment process is hampered by labor union rules, generous unemployment compensation, and ample food stamps. 

Similarly, double-digit inflation causes businessmen to hedge for financial survival. They tend to invest their working capital in those real goods they know best, in inventory and capital equipment. Funds that were serving production for the market become fixed investments in durable goods that may escape the monetary depreciation. Economic output, especially for consumers, tend to decline, which raises goods prices and swells the unemployment rolls.

—Hans F. Sennholz, “The Causes of Inflation,” in Age of Inflation (Belmont, MA: Western Islands, 1979), 37.

How Was It Possible that a Rich Nation, France, Let Her Finances Deteriorate to the Point of Literal Bankruptcy?

How was it possible that a rich and self-respecting nation let her finances deteriorate to the point of literal bankruptcy? Why let the hard money reserves go down the drain? Why permit herself to sink to the level of an international beggar? Why risk the breakdown of her most highly valued political institutions for which bloody revolutions and wars had been fought? An inflation-ridden France had lost her international position as a major power. 

Unfortunately for France, the Poincare-stabilization of 1928 was barely more than a year old when the global depression came along. It caused less suffering in France than in any other country; the number of unemployed never reached beyond a very moderate 400,000. But prices, working hours, take-home wages, profits, and capital values fell. It was simple to blame it all on the return to gold. With the automatic gold standard abandoned in 1936 — the manipulated variety of monetary standard was subjected to devaluations and restrictions, to be replaced in 1939 by a “closed” paper money system — the belief in saving and economy, in the free market, and in the welfare-creating incentives of the price mechanism fell into disrepute. 

A popular front of communists and socialists, followed by Petain’s fascist State, was a natural breeding ground for bureaucratism — and for legalized robbery, as Premier Reynaud branded, in 1939, the inflationary practices. But socialists and fascists were mere pikers in inflation compared with the full-fledged Welfare State that emerged from France’s liberation in 1944. 

A decisive influence was the Keynesian philosophy that became dominant in France, under Anglo-American influence, after World War II. Its basic tenet was that due to its inherent propensity for saving (hoarding?), a free enterprise economy is hell-bent for depression — mass unemployment — in perpetuity. The Keynesian answer was: perpetual inflation, with the government planning and directing investments, if not prices, wages, and many other functions as well. Distributing “purchasing power” was to provide stable employment, and let such “antiquated” concepts as monetary stability (and all economic freedoms, for that matter) hang. This crude revival of the crackpot doctrines current in the 17th Century suited the communist and socialist doctrinaires; it was a godsend for the power-minded politician (like Mendes-France, a leading self-styled “liberal”) and the job-conscious bureaucrat. Both groups, and their intellectual fellow-travellers, found a most convenient rationalization, or alibi, in favor of ever-more inflation: compassion for the fellow citizen’s sufferings due to the inflation — that was eagerly promoted by the same humanitarian bureaucrats and politicians. 

—Melchior Palyi, A Lesson in French Inflation (New York: Economists’ National Committee on Monetary Policy, 1959), 15-16. 

The Federal Reserve Has Been Following in the Shadow of the Bank of Japan by Mimicking Its Policies Since the 2000s

Since the 2000s, Federal Reserve officials have been following in the shadow of the Bank of Japan, mimicking its policies to no avail. For reasons we examine in the paper, Federal Reserve officials have largely ignored the Japanese experience. Yet the results of Federal Reserve policy have been disappointing. The bursting of the dot-com bubble was followed by a period of then-extraordinarily low interest rates. Those rates inflated a housing bubble, which also burst, resulting in the Great Recession. The Federal Reserve then engaged in rounds of large-scale asset purchases, or quantitative easing policy (QEP). That was part of a zero interest rate policy (ZIRP). 

Like the Japanese experience, the US recovery has been weak by almost any measure. To name just one, the US economy has gone a decade without one year of at least 3 percent real GDP growth. That is a historical record of economic weakness. There are proposals for institutional redesign of the central bank (e.g., Cochrane and Taylor 2016; Fed Oversight Reform and Modernization Act of 2015, H.R. 3189). These discussions and legislative proposals would benefit from considering the Federal Reserve in the shadow of the Bank of Japan. Though not well known, many fundamental issues of Federal Reserve policy and institutional redesign, as well as the political economy of constraints on central bank policy, have been experienced by the Bank of Japan well before they became issues in the United States. In fact, the policy discussion in Japan about central bank policy in the context of other policies has been far more transparent than discussion in the United States. . . .  

Hence, the bubble economies in both Japan and the United States have common ground. Both bubbles were the outcome of easy monetary policy in the context of a flawed financial system that directed imprudent lending to specific economic sectors supported by government guarantees and incentives. In both cases, financial regulators and supervisors failed to appreciate the feedback between increasing asset prices and lending. And, in both cases, central bank officials failed to appreciate the interaction between the structural flaws of the financial system and monetary policy. 

As long as government financial policy and the structure of the financial system go unchanged, central bank policy errors are amplified. The asset bubbles, their bursting, and the subsequent economic and financial distress illustrate the problems central banks face. When their respective governments use the financial system to pursue industrial and social policies, central banks cannot pursue price stability without inflating asset bubbles. The behavior of spot prices no longer provides reliable information about economic stability (Leijonhufvud 2007). 

—Thomas F. Cargill and Gerald P. O’Driscoll Jr., “The Federal Reserve in the Shadow of the Bank of Japan,” Journal of Private Enterprise 33, no. 1 (Spring 2018): 47-48, 53.

The Central Issue in Macroeconomic Theory Is the Extent to which the Economy May Be Regarded as a Self-Regulating System

The central issue in macroeconomic theory is the extent to which the economy, or at least its market sectors, may properly be regarded as a self-regulating system. While the general belief in the superiority of self-regulating, polycentric, market-based economic systems had undoubtedly been intensified since the collapse of the former Soviet Communist system, now two decades ago, in the field of money and banking authoritative economists still adopt a radically different stance, and go on developing proposals for what are essentially new variants of central planning in monetary matters. 

While it is today seldom contested that we can rely on self-regulating, decentralized, market-based systems as far as the production and allocation of commodities in general — such as automobiles, computers etc. — is concerned, in the field of money and banking the monocentric presupposition still almost universally prevails: in order to function properly the monetary and banking system has to be constantly monitored by a central agency, viz. by the central bank. A number of economists have nevertheless recognized the inconsistency implicit in this special treatment of the monetary and banking sectors as contrasted with economic issues in general, and have developed models of decentralized monetary and banking systems which are supposed to function as polycentric, self-regulating orders. While the general direction of this branch of research can be welcomed with some enthusiasm, the ways in which the “details” of some of the better known proposals for “free banking” have been elaborated until present, remain subject to a certain amount of well-founded criticism. The recent republication by the Ludwig von Mises Institute of Larry Sechrest’s Free Banking offers an opportunity to draw special attention to two particular claims revealed by the argumentation off the free bankers which struck this author as rather questionable. 

—Ludwig van den Hauwe, “Free Banking, the Real-Balance Effect, and Walras’ Law,” Procesos de Mercado: Revista Europea de Economía Política 7, no. 1 (Spring 2010): 242-243.

Keynes Transformed Fractional Reserve Bankers from Economic Villains Who Cause Depressions into Economic Heroes Who Enrich Society

Many critics of John Maynard Keynes attribute the success of his ideas to political appeal. No doubt, politicians are attracted to Keynesian economics because it can be used to justify profligate government spending. While important, political appeal alone cannot totally explain his triumph. Since Keynes’s theory is purportedly an economic theory, it could have never prevailed without the economists. So why does Keynes’s theory attract so many economists, and the most influential economists in particular? The answer is that influential economists in the banking system are attracted to Keynesian economics because it can serve as an economic justification for fractional reserve banking. The Keynesian interpretation of fractional reserve banking is an important reason Keynes’s theory conquered the economics profession.

Economists were becoming increasingly critical of fractional reserve banking in the years before Keynes published his theory. Even Alfred Marshall, the founder of the Cambridge school of economics, argued fractional reserve banking amplifies the business cycle. In 1912, Ludwig von Mises showed that fractional reserve banking is the fundamental cause of the business cycle. The Great Depression led many eminent American economists, including Irving Fisher, Frank Knight, Henry Simons, and Jacob Viner, to advocate abolishing fractional reserve banking. In fact, it was the American backlash against fractional reserves in the early 1930s that led directly to the formation of the Chicago school of economics. During the Great Depression, Senator Bronson Cutting and other politicians in the United States introduced legislation to abolish fractional reserve banking. 

Keynes’s theory was a godsend for the defenders of fractional reserves. Pre-Keynesian economics showed fractional reserve banking causes the business cycle and thereby makes society poorer than it otherwise would be. Before The General Theory of Employment, Interest and Money (1936), the defenders of fractional reserve banking had no answer to the pre-Keynesian analysis. But Keynes gave defenders of fractional reserves a weapon with which to combat the pre-Keynesian analysis. While the pre-Keynesian theory shows fractional reserve banking destroys wealth, the seemingly scientific New Economics purports to show that it is good for the economy. Rather than impoverishing society, fractional reserve banking actually creates prosperity in Keynes’s system. In short, Keynes transformed fractional reserve bankers from economic villains who cause depressions into economic heroes who enrich society. It is no wonder so many influential economists in the banking system have enthusiastically adopted Keynes’s theory.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 40-41.

Hayek’s “Profit, Interest and Investment” (1939) Is a Theoretical Explanation of the High and Persistent Unemployment of the 1930s

It is usually assumed that, while John Maynard Keynes developed a theory of chronic unemployment, Friedrich August Hayek did not. Indeed, a theory like this one was never explicitly explained by Hayek. 

However, we defend “Profit, Interest and Investment” (1939a) was written as a theoretical explanation of the high and persistent unemployment of the 1930s. We believe that the assumptions chosen by Hayek reveal that intention: “We shall start here from an initial situation where considerable unemployment of material resources and labor exists, and we shall take account of the existing rigidity of money wages and of the limited mobility of labor. More specifically, we shall assume throughout this essay that (. . . ) money wages cannot be reduced (. . . )and finally, that the money rate of interest is kept constant.” These assumptions are similar to the institutional and macroeconomic conditions of the British economy in the late 1930s. Besides, these assumptions are radically different from those chosen in Prices and Production (1931). In that book, Hayek assumed as a starting point in his discussion, a) full employment, b) labor mobility, c) flexible wages and d) flexible rate of interest. Thus, we believe that Hayek tried to adapt his model to the new circumstances. 

We will argue in this paper that this essay could be interpreted as a theory of chronic unemployment and economic stagnation. Also, it will be defended that this phenomenon has its explanation in a dynamically inefficient design of some of the institutions that rule the market.

—David Sanz and Juan Morillo, “The Hayekian Theory of Chronic Unemployment,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 14.