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Is Easing the Answer?

May 26, 2003

Frank ShostakIn his testimony to the Joint Economic Committee on May 21st, the Chairman of the Federal Reserve Board, Alan Greenspan, said that the Fed views deflation as a potential threat to the economy. For the time being, however, the Fed Chairman believes that the likelihood of deflation is not very high. 

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

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

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

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

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

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

So if the economy weakens and demand for reserves follows suit, in order to prevent a fall in the Fed Funds rate below the target, the Fed will be forced to slow down, or even contract monetary injections. According to Milton Friedman this is precisely the error that the U.S. central bank committed during the 1930's when a low interest rate was interpreted as an indication that the monetary stance was easy[1]

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

In pursuing an easier monetary policy stance, for example, the Federal Reserve would expand the supply of reserves until this easier policy stance registered on intermediate indicators or guides deemed reliable in low inflation environments. Monetary aggregates or market price indicators might serve this latter purpose. Reserves could be increased, for example, until some specified reflation occurred in broad commodity price indices, thereby signalling that deflation concerns are on the wane.[2]

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

The belief that this is the right policy to overcome an economic slump on account of price deflation emanates from Milton Friedman’s and Anna Schwartz’s research, which concluded that the reason for the Great Depression of 1929–1933 was the failure of the Fed to prevent a collapse in the money supply.[3]

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

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.[4]

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

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

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

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

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

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

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

On this Mises wrote,

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. [5]

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

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

According to Mises:

As the operation of the market tends to determine the final state of money's purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great, or small . . . the services which money renders can be neither improved nor repaired by changing the supply of money. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. [6]

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

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

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

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

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

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

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

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

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

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

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


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

[1] Friedman, Milton, and Anna Jacobson Schwartz. 1965. The Great Contraction 1929–1933. Princeton, N.J.

[2] Jim Saxton, Vice Chairman Joint Economic Committee United States Congress May 2003.

[3] Friedman, Milton, and Anna Jacobson Schwartz. 1965. The Great Contraction 1929–1933. Princeton, N.J.

[4] Remarks by Governor Ben S. Bernanke on Milton Friedman's Ninetieth Birthday, November 8, 2002.

[5] Mises, Ludwig von. 1966. Human Action, 3rd rev. ed. Contemporary Books. P. 421.

[6] Ibid.


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