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The Irony of Monetary Policy

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Tags Fiscal TheoryMonetary TheoryOther Schools of Thought

09/07/2006Vladimir Menshikov

Few Keynesians command more respect than James Tobin, at least on the subject of monetary policy, so this article seems to offer a convenient point of reference for an analysis of the prevailing view on the efficiency of monetary policy in assisting the macroeconomic performance of an economic system.

The fate of economies depends crucially on the economic doctrines they adopt. And Tobin is fully aware of this truth. In comparing the macroeconomic performance of the United States with that of European countries in terms of GDP growth and unemployment, he argues that the greater success of the United States is due to the "fine-tuning" Keynesian approach of the Fed as opposed to the rigid and conservative "monetarist" inclined policy of European central banks. While the Fed was determined to navigate the US economy between the twin dangers of recession and inflation, European central banks took an easy stance and concentrated their efforts solely on price stability, while disregarding the by far more serious threats of slow growth and high unemployment rates.

In the present article, I'm not going to analyze the pros and cons of the alternative approaches to monetary policy that Tobin focuses on: discretionary policy or adherence to a strict rule for growth of monetary aggregates. (Incidentally, I happen to believe that neither one of them is the best choice available to us.) Rather, I would like to touch upon the analysis of factors that would lead us to identify monetary policy itself (i.e., the inflation of the money supply by means of credit expansion) as the source of periodic fluctuations in the aggregate demand and unemployment.

Fiduciary Media, Debt, Bank Failures, and Deflation

As Tobin rightly notes, credit expansion as set by the decisions of the FOMC (Federal Open Market Committee) constitutes the standard operating procedure to inflate the money supply. However, far from being a neutral mechanism for "fine-tuning" the economy, credit expansion creates a host of problems that must lead to the dreaded deficiency of aggregate demand. It does so in a number of ways.

In order to understand the underlying process, let us briefly pause to review the role of the single most significant element in the process of credit expansion: the creation of new money in the form of demand deposits unbacked by standard money. People use demand deposits instead of actual cash because demand deposits offer many advantages in conducting financial transactions in addition to being as acceptable as ordinary currency. Writing checks and transferring money from one account to another is much easier than handing over actual cash, especially if large sums of money are involved or if transacting on a face-to-face basis is costly or unpractical.

Demand deposits as such are, of course, merely claims to standard money. If you have deposited your money in a bank you have a legal claim to your money and a right to withdraw it on demand. Standard money is any form of money that can be held in actual cash balances. For example, commodity money (gold and silver coins) and even fiat paper money are instances of standard money because they can be held and used for future transactions and represent no further claims to any other forms of money. Now, experience tells us that on average the amount of cash withdrawn from demand deposits is less than the amount of outstanding demand deposits. Such a situation offers a window to issue more claims than there is standard money actually deposited in banks' vaults. The fraction of demand deposits unbacked by standard money constitutes what Mises called fiduciary media.1 It is important to keep in mind that fiduciary media are as much a claim to standard money as "true" certificates.

Now, while fiduciary media are as good as standard money when it comes to paying bills and making all kinds of purchases, fiduciary media, unlike standard money, can under very specific circumstance be literally wiped out of existence. And as we shall see, a reduction in the amount of fiduciary media means an equivalent reduction in the quantity of money and a corresponding volume of aggregate demand in the economic system. Of course, this is the essence of the dreaded contraction in spending which, in turn, exerts a strong pressure on prices and wages to fall.

What are these special circumstances that cause fiduciary media to be wiped out of existence and thus the quantity of money and volume of spending to decrease? There are a number of them, and they all are very closely related to the process and degree of indebtedness.

The private banking system creates fiduciary media by creating demand deposits in excess of standard money through the granting of new loans.2 Now the amount of fiduciary media is exactly equivalent to the amount of new loans banks create in the process. The important thing to understand is that the quantity of money in the form of fiduciary media and, of course, the volume of spending which is supported by the fiduciary media, depends directly on the overall financial solvency of the system. As a general rule, financial solvency is threatened whenever a certain amount of outstanding debt cannot be repaid. In that case, banks that had granted "bad" loans might fail if their assets consist to a large extent of such loans and their other assets cannot cover the losses.

When and if banks are unable to meet their obligations and declare bankruptcy, then the outstanding checking deposits held at these banks lose the character of money and cease to be accepted as the equivalent of money by market participants.

It is therefore precisely in this sense that the quantity of money and the volume of spending are reduced. A reduced volume of spending diminishes sales revenues and people's incomes and therefore diminishes their ability to repay debts. This in turn causes even more banks to fail until eventually all fiduciary media can be wiped out, sending the entire system down the deflationary path. The process is exacerbated whenever bank runs occur. The runs occur because once people get wind of what bank failures can mean to their ability to salvage cash from their demand deposits, they attempt to withdraw and to hold on very tightly to whatever cash they manage to salvage.

This appears to have happened during the first years of the Great Depression in the United States. During that period the quantity of money fell by more than 25 percent precisely because many banks failed, wiping out a substantial fraction of the quantity of money in the form of fiduciary media. The volume of spending in terms of GDP fell by 50 percent. It should therefore come as no surprise that in the face of such a severe contraction in spending, piles of unsold goods and very substantial mass unemployment developed. The problem of mass unemployment was unnecessarily allowed to endure and even to become worse because of the widespread (mistaken) belief that reduction in money wage rates would cause aggregate demand to fall.

Fortunately, in recent economic history the Great Depression was the last such instance of a severe and prolonged depression, even though the importance of fiduciary media has been steadily growing since the thirties and so present financial conditions in every major industrial country have grown much worse than they were at the onset of the Great Depression. But as Ben Bernanke has promised, the Federal Reserve will never let a contraction of spending of such magnitude happen again. The Fed will supply however many new dollars are required to prevent the contagious spread of bank failures and widespread business failure, and to restore confidence in the system.

However, preventing deflation by means of increased inflation of the money supply lays the ground for a potentially greater threat: accelerating inflation resulting in hyperinflation. But accelerating inflation apparently constitutes the only available means the present monetary system is capable of offering against deflation.3 In the following, I would like to outline a positive case for why inflation tends to accelerate.

Credit Expansion, Illiquidity, and Debt

Inflation tends to accelerate in response to the immanent danger of deflation, which inflation, especially in the form of credit expansion, creates in the first place. It will therefore come as no surprise that attempts to cure the negative effects of inflation with even more inflation must lead to ever more problems, with accelerating inflation being the only apparent remedy to avoid slides into deflation.

To recognize clearly what factors tend to accelearte inflation, we need to take a closer look at the process that makes business firms and private households virtually dependent on the credit expansion.

In the absence of credit expansion, the primary source of cash balances, and loanable funds in general, is funds saved out of sales revenues. Because savings out of sales revenues and incomes represent the only source of cash, business firms and private individuals adjust the size of their cash balances to the overall expected volume of their financial operations. Credit expansion distorts the balance that exists between the perceived need for holding actual cash balances and the expected volume of financial transactions by decreasing the need and consequently the desire to hold these cash balances. It does so in several ways.

First, as new and additional money in the form of credit expansion enters the loan market, it drives down the rate of interest and so enables business firms and consumers to borrow relatively more than they were previously able to. Because it has now become relatively easier to obtain needed funds, businesses tend to lower the rate of their cash holdings relative to the expected volume of their financial transactions.

Second, as the new and additional money spreads throughout the system it also increases people's sales revenues and incomes. And as the thus-elevated sales revenues and incomes are spent and respent, practically everyone experiences the benefits of a rising market and has more money to spend. To meet the sudden surge in demand for their products, businesses respond by building up additional inventories. And as the market goes on rising, the need and desire to hold money balances is further diminished because they expect to obtain more money through subsequent sales than they would if they let their cash balances remain dormant.

Another important effect of credit expansion on cash holdings is to be found in the pressure on the interest rate to increase. The rate of interest tends to increase because of the growing discrepancy between the elevated sales revenues (and profits) and the relatively low rate of interest caused by credit expansion. What we have here is simply an ever growing demand for loanable funds outstripping the supply of those funds. Now, a higher rate of interest makes it more profitable to lend out short-term sums of money out of available cash holdings, thereby diminishing the size of those holdings.

And, finally, as a result of the continuous inflation of the money supply prices of all kinds of goods and services begin to rise and people begin to expect prices to go on rising, it becomes even more unprofitable to hold cash balances. This is because holding actual cash when the prices of virtually everything in terms of paper money results in rapid losses of the purchasing power of the money. Substituting real goods for cash becomes indispensable in order to preserve at least a fraction of the purchasing power of one's sales revenues or incomes.

In addition to making business and households illiquid, credit expansion induces them to go deeper into debt. Since the inflation drives up people's sales revenues and incomes, it appears profitable to borrow against those higher revenues and incomes. People go into debt more deeply the more leverage the low interest rates provide them and the higher they expect their incomes to rise. Greater indebtedness is also virtually assured simply because in the boom phase there is a widespread anticipation of prices of common stocks or real estate to continue rising. And so, many people borrow in the speculation of achieving a higher net-worth position in the future.

However, it must all come to a bitter end once the objective basis for low interest rates and ever increasing stock and housing prices (namely, the creation of new and additional money) stops or fails to accelerate with expectations. And so the system threatens to disintegrate because of the combination of the two factors just described: illiquidity and indebtedness. Now as credit expansion stops and the objective cause of reduced demand for money is removed, people begin to scramble for funds. Naturally, the only way to deal with a diminished cash balance is to rebuild it, which in general can only be achieved through a fall in spending for goods and services. The immediate effect is again to worsen the debt burden of business firms and households. A further consequence is, of course, the occurrence of an increasing number of business and personal bankruptcies producing an immanent potential for widespread bank failures and further reductions in the money supply and the volume of spending.

Now, since the "loose" monetary policy represents for many the only known remedy for contraction in business activity, any sign of impending contraction literally forces central banks to accelerate the speed of the printing presses. Incidentally, the "'double-dip' recessions of 1979-1980 and 1981-82, vanquishing the double-digit inflation of 1979-80," which Tobin refers to in his article, came about precisely because the Fed and the government had at last recognized that if they were not sufficiently determined to stay away from the money press (thereby letting a recession and mass unemployment develop), they would have to let the economy go down the hyperinflation whirlpool with all its fatal consequences. And, contrary to what Tobin thinks, no amount of fine-tuning would have helped to avoid the choice Volker and his Fed faced at the time.


We can summarize by stating that inflation of the money supply, especially in the form of credit expansion, creates the very phenomenon of fluctuations in aggregate demand that Tobin and other Keynesians consider to be remediable with even more inflation. What needs to be understood clearly is the mischievous nature of the governmentally sheltered fractional-reserve banking system, which has always been at the root of the trade-cycle problem. The sequence of events is always the same. In the boom phase, when the volume of fiduciary media expands, businesses and private households become increasingly illiquid and heavily indebted because of the prospect of easily obtainable credit. But as inflation of the money supply results in higher prices, people begin to worry, and monetary authorities take necessary steps to slow down the growth of the money supply, thereby removing the foundation for the relatively low cash balances. Hence, the resulting sudden increase in the demand for money with all the consequences described above.

And if, instead of allowing bankruptcies to occur and prices and wages to go down to restore financial health, central banks decide to avoid deflation by inflating the money supply even more, the problems produced by previous rounds of credit expansion are not only not remedied but further exacerbated, which can lead to hyperinflations and the destruction of the economic system.

However, it must be pointed out that it is highly unlikely to see actual hyperinflation any time soon in the developed economies. Since central banks and governments in the more developed countries have developed a relatively low tolerance for price inflation, the recurrence of periodic "busts" to contain inflation appears to be a likely course of events. In terms of the relative frequency of "boom-bust" cycles, we find ourselves precisely where we were without the "monetary policy".4

  • 1. See Ludwig von Mises, Theory of Money and Credit, Ch. 16.
  • 2. There are two ways for fiduciary media to come into existence: by lending standard money that has been previously deposited in checking accounts and by creation of additional checking deposits without releasing additional standard money into circulation. For a full and excellent description of the process, see George Reisman, Capitalism: A Treatise on EconomicsDownload PDF, pp. 512-13.
  • 3. There is an alternative pretty much worth to be considered, namely, the establishment of a 100-percent-metalic-reserve system. Such a system would eliminate not only the dangers of inflation but of contractions in spending, resulting recessions and sudden increases in unemployment as well. For an analysis of why a 100-percent-metalic-reserve system would provide the maximum of economic stability, see George Reisman, The Anatomy of Deflation and The Goal of Monetary ReformDownload PDF. There has also been developed a number of proposals of how to make a transition from the present fiat money system to a 100-percent-metalic-reserve system as smoothly as possible. In my judgment, the best proposal is offered by George Reisman in his book CapitalismDownload PDF, cf. ibid. pp. 959-63, hear also his mp3-lecture on Monetary Reform.
  • 4.
    Christina Romer, a prominent mainstream macroeconomist, argues here that empirically the frequency of business cycles seem not to have improved despite all massive attempts to "fine tune" the economy.

Vladimir Menshikov

Vladimir Menshikov is a PhD student at the University of Turin.

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