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Monetary Policy and Financial Crisis

Mises Daily: Wednesday, November 07, 2001 by

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In Defense of Free Capital Markets: The Case Against a New International Financial Architecture. By David DeRosa. (Bloomberg Press: 2001) $19.56.

David DeRosa’s latest book, In Defense of Free Capital Markets, has been hailed by such eminent economists as Milton Friedman, Anna Schwartz, and Steve Hanke as one of the best libertarian contributions to the debate on international capital markets. DeRosa’s book is especially refreshing considering the current debate, which is dominated by calls for more regulations and the introduction of an international lender of last resort.

Its publication is all the more timely given the financial crises (in Asia, Brazil, Russia, and Argentina) and stock market crises (in the U.S.) that littered the 1990s. Without underlying changes to the financial system, these will continue. The problem with DeRosa’s book is that his solution offers no hope for stabilizing the system.

David DeRosa takes readers through the main crises of the 1990s while stressing the fact that most of them occurred in countries whose economic policies were the least coherent. His historical analysis is most refreshing and instructive in the sections on Japan. DeRosa reminds us that global reflationary policies to stimulate demand have failed. Even fiscal policies have been only partly effective in a context of an industrial policy that has prevented agents from innovating by themselves. DeRosa points out, quite rightly, that shareholders have had very little control over Japanese companies. He also reminds us that the economic downswing of 1997, after a satisfactory year in 1996, was largely due to an internal economic policy mistake (i.e., an incongruous increase of VAT from 3 percent to 5 percent).

He regards these industrial policies as the primary causes of the Asian crisis of 1997. These are indeed counterproductive because a complex economy can only work if it is decentralized. Only agents directly responsible for their own companies can adequately measure risks, propery examine profits and losses, and draw conclusions as to the future of their companies. The implicit insurance given by the State, for the losses of the company as well as for the depreciation of the exchange rate, has major disincentive effects on how agents assess risks.[1] DeRosa comes close to indentifying the phenomenon of malinvestment, in particular in Indonesia, but without referring to monetary policy as such. 

The role of companies' short-term debt is also identified.[2] South Korean companies (in particular the famous chaebol) were suffering before the crisis from chronic undercapitalization and from overinvestment in heavy industries sectors. Operators were seeking to gain market shares more often than not at the expense of profitability. Moreover the allocation of bank loans was orchestrated by the State to favor so-called priority sectors. Banks were so protected that they did not feel the need to develop their methods of credit analysis and risk management.

Finally the author is right to say that it is incoherent to desire an autonomous monetary policy in a fixed- exchange-rate system. Indeed the monetary authorities, who seemingly do not have the slightest grasp of microeconomics, should know that it is absolutely impossible to set a fixed price (the exchange rate) and a fixed quantity (the monetary supply).

However, DeRosa’s analysis is incomplete. His explanation of the stock exchange bubble in Japan between 1986 and 1990 epitomizes perfectly the errors contained in his book, and those of monetarists school in general. If the author does see that the bubble inflated because of an expansive monetary policy, he does not grasp the consequences of his analysis. This blindness stems from the trademark methodological errors committed by monetarists and more generally by positivists.

By only taking into account measurable phenomena (that can be confronted with facts), they fail to understand the implications of the disconnection between the natural interest rate[3] and the observed market interest rate. DeRosa cannot see that an artificial expansion of credit will benefit in priority the sectors of production furthest away from consumption (heavy industries, for instance) and will lead companies to invest in the most expensive and far-off projects. But these have no real corresponding demand and do not comply with agents’ desired intertemporal allocation.

Furthermore, as monetarists are macroeconomists, they cannot perceive a poor sectoral allocation of capital, because this phenomenon does not appear in indicators such as industrial production, gross domestic product, or the general price level.

The worst part of DeRosas’s book comes when he advocates measures to help Japan out of its economic sluggishness. Indeed, as does Milton Friedman, DeRosa believes that lower consumption prices could lead to a deflationary spiral and that the way out is to practice an expansionary monetary policy.[4] Therefore he recommends an increased amount of open market operations to inflate the monetary base.[5]

But the problem is that monetarists do not have a cycle theory. They do not see that deflation is an unavoidable consequence of an inflationary boom and that it paves the way for a healthy recovery by re-creating incentives to save and to invest in profitable projects.[6] Extending inflation, on the other hand, extends the crisis and the cycle of mistakes. Moreover, inflating the money supply is no way to encourage banks to clean up their balance sheets when they are plagued by bad debt.

The stability of the international financial system requires widespread reforms and especially a change of mentalities. DeRosa asks that stock exchanges remain largely unregulated.[7]  But that is not enough. Indeed, States are always intervening on financial markets, by modifying the cost of refinancing and especially by creating money artificially via open market operations. That is what creates bubbles and leads them to burst.

Allowing exchange rates to float is an interesting idea because it helps avoid the conflict between external aims (the determination of the exchange rate) and internal ones (the regulation of global demand). This does reduce the probability of a violent speculative reaction. But allowing exchange rates to float is also the source of great folly. To let a government choose a monetary policy on its own discretion is to pave the way for a cyclical economy. In a world where demands for profitability are ever greater and where it is technically easy to withdraw huge amounts of money from a country in a matter of minutes, a flexible exchange rate would not prevent a crisis of balance of payments due to the distrust of investors.

The stabilization of the international monetary system requires the complete neutralization of monetary policies. The introduction of a currency board or pure and simple dollarization will only solve one part of the problem. These measures prevent governments from indulging in their hyper-inflationary inclinations.[8] In this case, monetary policy depends directly on that of the reserve-currency’s country. Therefore a currency board and dollarization lead to the international synchronization of economic cycles. Furthermore, it is costly and politically difficult to give up national currencies, as was shown by the frighteningly technocratic construction that was needed to convince European countries to take on the euro.

A more reasonable solution, and more realistic politically speaking, would be to set a weight in gold for national currencies.[9] If we take the example of the dollar, the answer is not to set an exchange rate between the dollar and gold, but to decree that a dollar represents X ounces of gold and that it can be exchanged, at all times, for this quantity, domestically or internationally.

Exchange rates would be fixed, not due to governmental control, but because they would be defined in relation to a same good (silver or gold). International trade would no longer have to suffer from changes in exchange rates between counties with different monetary policies.[10] I speak about gold here because I believe that it is the good which is best to fulfill a monetary role B, but that is far from being the most important point. Other goods could freely emerge depending on market needs.

To conclude, DeRosa’s historical analysis is interesting, but his monetarist analysis is often wrong. Therefore, it is all the more regrettable that there should be so few Austrian contributions to this field. When Mises first exposed his cycle theory, he wanted to explain the internal economic evolution of a country by basing himself on the Currency School’s theory of international monetary flows. The Austrians have focused on a closed economy but to the neglect of international finance. Today, on the contrary, it is necessary to apply Mises’s model to an open, international economy.[11]


Nicolas Bouzou is an economist working in Paris, France.  Send him MAIL.


[1] The problem of risk externalisation in Japan is referred to by Roger Garrison in Time and Money: The Macroeconomics of Capital Structure, 2001, New York, Routledge (p.121).

[2] However the author fails to point out that companies' excessive debt is always the consequence of an expansionary monetary policy which allows the multiplication of credit.

[3] I.e. the interest rate that equalises demand and supply of real savings

[4] Milton Friedman wrote in the Wall Street Journal (December 17,1997): A The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift to tight money to easier money.

[5] p.54 A The resultant swelling of the Bank of Japan's balance sheet and expansion of the money supply might avoid the further disaster of a deflationary downward spiral in consumer prices @.

[6] See Murray Rothbard, America's Great Depression, 1975, Sheed and Ward. Reagan was actually all in favor of this idea before Milton Friedman talked him out of it.

[7] p.xiii : A [The book] makes the case for allowing the international financial market to remain largely unregulated.

[8] That is why DeRosa is wrong when he writes p.222 that 122 A a currency board is the most interventionist of all foreign exchange regimes. On the same subject, see Kurt Schuler, Lars Jonung et Steve Hanke : Russian Currency and Finance: a Currency Board Approach to Reform, 1993, Routledge.

[9] See Murray Rothbard, The Case for a 100 Percent Gold Dollar, 1991, Ludwig Von Mises Institute.

[10] See Murray Rothbard's fundamental book : Rothbard What Has Government Done to Our Money?, 1985, Libertarian Publishers.

[11] That is what Anthony Mueller does in his article Financial Cycles, Business Activity and the Stock Market, The Quarterly Journal of Austrian Economics, Spring 2001 (Vol. 4).