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How Much Money Does an Economy Need?

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Tags Financial MarketsMonetary TheoryOther Schools of Thought

08/05/2008David Gordon

[How Much Money Does an Economy Need? Solving the Central Economic Puzzle of Money, Prices, and Jobs. By Hunter Lewis. Axios Press. Vi + 185 pages.]


In Are the Rich Necessary? Hunter Lewis showed himself to be a master of dialectics; and he here applies the same method to monetary theory. Not content to expound his own views, Lewis carefully explains conflicting standpoints as well. Lewis does not disguise his own strong commitment to Austrian economics, but the reader of this book will understand not only this position, but its chief competitors as well.

Lewis begins by asking, what kind of prices do we want? At first, we might think that stable prices are the order of the day. If the price level fluctuates, does this not make economic calculation much more difficult? If the price level is rising, for example, businessmen may think they are making profits when they are in fact losing money. They may neglect to discount their paper profits by the rate of inflation. This position at times won the allegiance of the great monetary economist Irving Fisher, though sometimes, as Lewis notes, Fisher adopted a more inflationist view.

Against the policy of stable prices, though, there are insurmountable objections. In a free-market economy, as production expands, many prices tend to fall. Formerly expensive goods now can be produced in large quantities. This is all to the good, as it makes possible rising standards of living. As Mises long ago noted, capitalism is a system of "mass production for the masses." If these prices fall, then attempts to maintain a stable price level require that other prices be artificially boosted. Will doing this not introduce shortages and discoordination into the economy? Far better to leave things as they are.

The whole point of free markets is to keep reducing prices, so that more and more people can afford to buy. Why, then, should we want overall prices in our economy to remain stable? If most prices fall, as we should hope they will, stable prices overall can only mean that some prices are steeply rising. These rising prices make everyone poorer, but especially retired and poor people… (p. 5)

But, supporters of inflation refuse to accept this conclusion. Even if boosting prices does result in some discoordination, they maintain, the advantages of increasing prices outweigh the disadvantages. This is particularly so in times of depression and unemployment. Those who favor deflation and price coordination through the market will say that if unemployment exists, wages need to be adjusted downwards. Is not such a draconian policy too hard on workers? Far better to deal with unemployment through an expansion of spending. So, at any rate, Lord Keynes contended.

Austrian economics shows the error in the Keynesian argument. When unemployment exists, the problem is not that wages in general are too high. Rather, particular wages need to be adjusted. A general policy of inflation may mean that workers will not face monetary cuts in wages, but the underlying discoordination remains. Further, if inflation lowers workers' real wages, the Keynesian policy also involves cuts in wages. Why is a decline in monetary wages supposed to be worse than a fall in real wages?

Additionally, W.H. Hutt has pointed out that inflexible wage rates generate sub-optimal employment. If wages cannot fall, employers will discharge workers, who will often have to secure employment in jobs for which they are less suited than those they would hold in a free market.

As Hutt warned, "Chronic unemployment is conspicuous… Yet the wastes implied under 'sub-optimal employment' are, as I [Hutt] see things, normally the most virulent form which wastes can take." (p. 14, quoting Hutt)

In response to Keynes's contention that reducing wages in times of depression is "too hard" on workers, Lewis makes an insightful point. Why should workers be able to benefit from good times but not have to suffer any diminution in income in bad times?

Is it reasonable to advocate wage freezes when prices plummet, but permit unlimited wage increases when prices soar? Why should wages be inflexible only on the downside? (p. 45)

The question of how to deal with depression raises a more fundamental issue: what is responsible for depression in the first place? Lewis offers an excellent account of the Austrian theory of the business cycle, by far the most cogent explanation of business downturns.

As Lewis notes, cycles cannot be blamed on the free market. The flaw that makes the cycle possible is fractional-reserve banking, in which a bank is permitted to create credit in excess of the deposits that have been made to it. The bank is required only to maintain a certain ratio between deposits on hand and its credit expansion. A free market need not incorporate fractional-reserve banking; it can, instead, institute the alternative 100% reserve system. Indeed, Murray Rothbard argued that a free market required this latter arrangement. The fractional-reserve system is the artifact of particular legal decisions. Lewis calls attention in this connection to two decisions of British courts in the early nineteenth century.

An effort to require banks to maintain 100% reserves against all deposits failed in British courts in 1811 and 1816. The House of Lords also confirmed the right to maintain fractional reserves in 1848. (p. 55)

How does fractional-reserve banking make the business cycle possible? The problem arises if the government, in an effort to promote prosperity, increases the generation of bank credit. (Lewis discusses in detail various ways in which the Federal Reserve System can do this.) The increase in the money supply lowers the monetary rate of interest. Investment then increases: because business loans are available at lower interest rates, projects that were formerly unprofitable are now feasible. Business then expands, especially in capital goods.

Trouble — usually sooner rather than later — arises. The interest rate is not in essence a monetary phenomenon. Quite the contrary, interest reflects time preference, the rate at which people prefer present goods to future goods. This rate will not in general alter just because of the monetary expansion. The lowering of the interest rate thus proves a temporary affair, and the interest rate rises to reflect time preference. As a result, some of the new investments prove unprofitable and must be liquidated.

In the Austrian view, this liquidation ought to be allowed to proceed unhindered. Should the government attempt to alleviate matters by further monetary expansion, the result will be another artificial boom that will again require correction. The necessary liquidation cannot be indefinitely deferred. If the government continues its expansionist course, the upshot will be hyperinflation and the collapse of the monetary system altogether.

Keynes denied this analysis. In what to my mind is the best part of the book, Lewis finds the essence of the Keynesian system in this point. Keynes did not merely preach a policy of government spending in order to get around the supposed problem of wages that are rigidly downward in a depression. He claimed that boom conditions could be made permanent. The interest rate could be driven down almost to zero; doing this would greatly increase investment, thus bringing about permanent prosperity. Investment, further, should not depend on the vagaries of capitalists' "animal spirits"; instead, investment should be to a large degree socialized.

The remedy for the boom is not a higher rate of interest but a lower rate of interest. For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom. (p. 35, quoting Keynes)

In his stress on lowering the rate of interest to zero, Lewis has independently arrived at the same view of Keynes as that of Roger Garrison, in his Time and Money: The Macroeconomics of Capital Structure (Routledge, 2001) 1. But Garrison's excellent book is intended mainly for his fellow economists. Lewis explains the issues in clear terms that everyone can understand.

Keynes's theory is, on Austrian grounds, obviously unacceptable. But the Austrian theory has itself been subjected to various criticisms. Can it successfully withstand them? Lewis offers a convincing response to one of the most serious of these. As the theory has it, increased bank credit will induce more investments; some of these investments fail because the monetary interest rate is artificially low. But does not the theory assume that businessmen will act foolishly? What if they realize that the increased money supply does not reflect the rate of time preference and, as a result, do not seek new loans to expand investment? No business cycle will result.

Lewis responds in two ways. First, it is often hard to judge what the correct rate of interest should be:

[A] business owner may know that today's rate of interest is artificial, unsustainable, and misleading but he or she cannot know what the rate would be without government interference, and without this vital information can only guess at the best course. (p. 74)

Further, businesses that reject new money will simply lose out in market share to competitors. Unless a businessman can forecast when the crash will occur, it is to his advantage to take the new money and stay abreast of the competition.

An additional point merits consideration. As Mises noted in "Elastic Expectations and the Austrian Theory of the Trade Cycle" (Economica, August 1943), the aim of the Austrian theory is to explain those cycles that do occur. If businesses do not "take the bait" of loans at artificially low rates, there will be no boom; but if they do, a boom will occur. The theory thus shows how a boom may arise; it need not, to count as a good theory, postulate a process that invariably generates a cycle. In science, there are laws of tendency as well as laws that state an invariable causal relation.

How Much Money Does an Economy Need? is an outstanding guide to the essentials of monetary theory. If the literate public absorbs its lessons, the book cannot fail to have a salutary effect on current economic policy. Hunter Lewis deserves congratulations for his notable achievement.

  • 1. See my review in The Mises ReviewSummer 2001.
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