The Special Importance of Austrian Economics to Young People

As faculty advisor to the “Students for Austrian Economics” club at the University of Iowa, I was asked to speak to the group about the importance of Austrian economics in the world today and why it is especially important to young people. I was flattered by this request, because I admire the courage of the members of this group who stand against most of what they hear every day about how the world works. But I was also challenged to state clearly something that I had not considered for some time. Although I read Austrian economics almost exclusively, I had not thought much about why I read it—to me it was self-evidently true. Therefore, I found it a challenge to state the case for Austrian economics to members of the club who might not be as devoted to the discipline as I am and who desire to be convinced.

Road Map for Government Policy

First of all, Austrian economics is important to everyone, not just young people, because it provides a road map for government policy. Wrong government policy can destroy nations and entire civilizations. I fear that we are on the path to just such destruction right now. But why I think this does require some basic understanding of just what Austrian economics is.

I prefer the definition of my friend Michael McKay, host of the weekly radio show Radio Free Market. Michael begins each of his shows with the statement that “Austrian economics is 'reality’ economics and reality is not optional”. There are two main elements of Austrian economics that make it real—its placement in the social sciences rather than the natural sciences and its emphasis on micro as opposed to macro analysis. Ludwig von Mises’ last book, The Ultimate Foundation of Economic Science, explained the proper place of economics in the social sciences, relying upon deduction from the rock solid foundation of irrefutable truths. Because we are dealing with man and his preferences, economics is not a natural science with its reliance upon empirical observation to discover natural laws from which to develop mathematical predictions of economic outcomes.

For example, we cannot with any certainty state that the recession will come to an end X number of months after the Fed injects Y amount of money into the system. But that is exactly what other economic disciplines, primarily Keynesianism, purport to be able to do. Austrian economics tells us is that increases in the money supply will debase all money currently in the hands of the public, reducing money’s purchasing power and redistributing the ownership of wealth assets. This is not a theory based upon empirical observation, but an economic truth deduced from irrefutable maxims.

This is important, because so much misguided policy flows from this very basic misunderstanding, and we are witnessing it right now. As Ludwig von Mises stresses in chapter 17 of Human Action, “catallactic precision cannot be applied to historical problems” and that “attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history.” Massive spending and monetary pump priming have not gotten the desired results that the current batch of Keynesian economists desired, so they are poised to engage in an even more radical step called quantitative easing. Quantitative easing just means that since the interest rate cannot be driven any lower than zero, the central bank must simply print money and give it to the government to spend as it pleases. And, since the Keynesians in government believe that economics is a natural science, they will point to their own meaningless statistics to rationalize their actions.

Spending Does Not Equal Prosperity

Nowhere is this dichotomy between Keynesians and Austrians more apparent than in how each school of economic thought would measure economic success. For example, we are constantly told by our government that the recession technically ended last year, because GNP stopped shrinking. Here is the great macro vs. micro approach. Whereas Austrians take the individual as the object of analysis, Keynesians place emphasis on GNP. And they measure GNP by total spending in the economy. Now let’s just look at this for a moment. For the Keynesians spending is the be all and end all. As long as people are spending, then they must be buying something that someone produces. Therefore, Keynesians equate spending with prosperity. If people reduce their spending and increase their savings, GNP will fall. When this happens, government spending must increase to replace private sector slack. Taken a step further, government spending can spur an economy to new heights, if private spending is not positive enough. Now isn’t this a wonderful theory--that government can spend the nation into prosperity? Unfortunately this isn’t working very well.

Austrians would not place any emphasis on total GNP, because spending does not equal prosperity. If a man spends a great deal, we may conclude that he earns a lot or it may just be that he is spending profligately. The latest spending craze in housing is an excellent example. Housing sales skyrocketed for years, but it turns out that many of these sales were to people who really could not afford to purchase them. They lost their homes when the bubble burst, which was a direct result of government making it appear as if more people could afford homes that was actually the case. Spending did increase, for awhile anyway, but it could not be sustained. Reality was not optional, after all.

By contrast the Austrians place all economic analysis on the individual, not society as a whole. The economy is just the aggregation of all individual decisions, so once you understand how individual men act you will understand how to make an economy work better. For example, Austrians place more emphasis on freeing man from the straightjacket of government taxes and regulations that prevent him from freely cooperating with other men in order to achieve his goals. Other men are seeking the same cooperation of him, so their mutual cooperation creates winners all around. Each expects to improve his situation. If we look only at what man spends, we really do not know whether he is creating wealth or consuming it.

Justice, Law, and Inalienable Rights

But Austrian economics is important for much deeper reasons. Whereas all other economic schools of thought are willing to sacrifice some members of society or citizens of other countries for supposed economic gains, Austrian economics emphasizes the importance of law, justice, and God-given inalienable rights that accrue to each and every individual. These are not a hindrance to economic progress but are part and parcel of economic progress. Not only does Austrian economics focuses on the welfare of the individual, it holds the life, liberty, and property of all individuals sacrosanct. Although few today openly call for persecuting minorities, most economic schools of thought denigrate the importance of private property. Some even openly support confiscating the property of the rich for redistribution to the poor. Austrians place property rights as an extension of individual rights, for without property man cannot survive. Thus, Austrian economics promotes not just a higher standard of living but it does so by holding the individual as an inviolate entity whose rights precede those of society and the state. This has further implications for international peace, for Austrian economics asserts that economic science does not end at political borders. The benefits of free exchange can and should extend to the entire world, spreading peace and prosperity instead of war and poverty. At no time since the end of the Second World War have governments expressed such outright hatred of foreigners and attempt to blame them for all economic ills. Even this week our own Secretary of the Treasury Timothy Geithner fanned the flames of international ill will by blaming our current economic woes on the Chinese. This is as preposterous economically as it is dangerous politically. This is a prime example of how an economic theory can lead nations to war—if a government really believes that Chinese economic policies are harmful to us, it will feel justified to protect us. When goods stop crossing borders, armies will. As Ludwig von Mises states in chapter nine of Human Action, it is the autarkic policies of hegemonic states that are the main cause of war.

The Young Can Free Themselves from Entrenched Ideas

We now conclude with why Austrian economics is so important for young people. The current Keynesian system has created an entrenched class who will never admit the limitations of their fervently held ideas, because they benefit from them. The government is a revolving door of Wall Street bankers, environmental activists, union supporters, and others dependent upon government interventions. They will never give up their power and their privileges. Therefore, it is up to a new generation who is not yet tainted by the corruption of government to “stand up for freedom”, as Michael McKay always ends his Radio Free Market show. Austrian economics provides the analytical tools to expose the reality of a corrupt system in which the few gain at the expense of the many. The young have a choice. They can join the corrupt system or they can throw it out. Will they choose peace and prosperity, or will they choose poverty and war?

My Letter to the Wall Street Journal re: Geithner Takes Aim at China Policy

Re: Geithner Takes Aim at China Policy

Dear Sirs:
The Geithner speech is nonsense on two levels. Number one, and most importantly, if a country holds its currency cheap, it is subsidizing the living standards of its trading partners. If the Chinese are foolish enough to subsidize our lifestyle--which, by the way, they have been doing for some time now--then why would we desire that they stop? Secondly, the logic of his argument is childish. If we think China's monetary policy is wrong, why are we encouraged to do the same thing? (I can just hear Mrs. Geithner asking her little boy Timothy why he jumped in the mud puddle...and little Timothy telling his mother that he did it because his friend did it.)

No country can force another country to pay its bills or cause another country to have higher unemployment. The most damage that a country can do to another is indirectly--by adopting policies that reduce its contribution to the world economy. For example, the world is worse off because Cuba is a communist country and does not produce goods for the world market.

Patrick Barron

My Letter to National Review re: Acting White

From: patrickbarron@msn.com
To: submissions@nationalreview.com; letters@nationalreview.com
Subject: Letter to National Review--"Moot Causes" needs one more step
Date: Mon, 4 Oct 2010 13:04:59 -0400

Dear Sirs:
A college professor friend of mine says that you need to ask "Why" at least five times to arrive at the root cause of something. Such is the case of "Moot Causes", Roger Clegg's review of Stuart Buck's book Acting White: The Ironic Legacy of Desegregation. Mr. Clegg lays the problem of "black students' rejection of academic achievement" at the high level of out-of-wedlock births--70%!--and the lack of a male role model in the lives of children. This undoubtedly has merit. But what is the cause of all those out-of-wedlock births? I believe the answer is economic regulation and the welfare state. Economic regulation has priced unskilled labor out of the market; there is no "first rung on the ladder" of the job market for many urban poor. But welfare entitlements prevent the outright destitution that would be the result of this market intervention. The result is the deplorable spectacle of multi-generational welfare dependency, crime, and other societal pathologies. End economic regulation AND welfare. Those on welfare will have the job opportunities they need, and, once again, school will be seen as the necessary preparation for a life of work rather than a prison to which one is sent by the truant officer.


Patrick Barron

Letter to National Review re: Bank of America, by Kevin D. Williamson

From: patrickbarron@msn.com
To: submissions@nationalreview.com; letters@nationalreview.com
Subject: Re: Bank of America by Kevin D. Williamson
Date: Tue, 28 Sep 2010 09:57:11 -0400

Dear Sirs:
Among many of Kevin D. Williamson's excellent and pointed comments about Obama's new "infrastructure bank" is this one: "...the Fed...whose managers pay the very highest prices for the very worst assets...". Mr. Williamson then exposes the bizarre world of government earmarks for projects that no one would fund if asked to do so privately. And herein lies the main problem--where does the Fed get all that money for its bloated balance sheet of dubious assets and where does the government get all that money for its new infrastructure bank? Well, it manufactures it out of thin air; in other words, it counterfeits it. The government commands real, scarce resources with non-scarce, fiat money. It has found the Midas touch, at least for awhile. But each expansion of the money supply reduces the purchasing power of money already in circulation in addition to causing structural dislocations, such as the housing bubble. Unchecked expansion of fiat money is undermining our economy and is the greatest threat to our nation today. Bizarre spending is merely a symptom of the disease.

Patrick Barron

Only a 132 Year Payback for the All-Electric Car!

There are few examples where government interference in the economy is more pervasive than energy. Now, the term energy encompasses a plethora of technologies, and each attracts the gimlet eye of Big Brother. In recent years environmental groups have been very successful in insinuating themselves into the halls of government so that today there is a revolving door between government and the environmental movement just like the revolving door between the government and other key industries, such as banking and the military-industrial complex. Government would have us believe that a new regulation is the result of some great, objective, and careful investigation. But mostly these regulations and spending programs are foisted upon us by the people who only yesterday were nothing more than lobbyists for some fervently held cause. There has been no new data, but yesterday’s lobbyist today carries the mantle of great authority and prestige as a high level government bureaucrat.

We economists call such lobbying “rent seeking” and those who engage in it as “rent seekers”. Rather than seeking the cooperation of other men in the free market, a rent seeker lobbies government to impose some special privilege. The cost of the rent seeker’s efforts is greatly reduced, because he need convince only a few elected officials or government bureaucrats rather than the entire market. His job is made all the easier by the knowledge that the elected official or government bureaucrat can grant the privilege with no cost to himself. And when a rent seeker gets a job in government itself, well, the fox is in the henhouse. Officials move billions of dollars and coerce millions of people with no responsibility whatsoever. If a program fails to achieve its grand design, no government official suffers the consequences. Furthermore, failed regulations are seldom repealed, because, despite the net burden to the economy, a few new constituents do benefit and lobby mightily to keep them in place.

A Revolving Door Lobbyist for the All-Electric Car

Such is the case as recently reported by the Associated Press in regard to a lobbyist for an all-electric car.
"Leading the Charge” glorifies Mr. David Sandalow, a U.S. Department of Energy assistant secretary and an avid advocate for the all-electric car. He has converted his Toyota Prius Hybrid into a plug-in hybrid at the cost of $9,000. Now Mr. Sandalow can recharge his car’s battery from his home electrical outlet. Unmodified hybrid cars recharge their batteries only while operating on their gasoline powered engines.

Mr. Sandalow is very proud that his daily five mile commute (a ten mile round trip) can be accomplished with a need for a gasoline refueling stop only "about once every month or two". Nevertheless his car needs to recharge after only 30 miles of travel, so he advocates that the government pursue developing a battery that will allow 100 miles between rechargings. The government itself estimates the cost of such a battery at around $33,000 per battery. (How the government knows this when no such battery yet exists was left unclear.) The article reassures us that government tax credits and stimulus funds will reduce the cost to the consumer to around $10,000 per battery. (But we Austrian economists know that government subsidies do not lower costs; they only change who pays. So it is disingenuous to say that government subsidies will lower the cost of such a battery.) Mr. Sandalow estimates that his electricity cost is equivalent to buying gasoline at $.75 per gallon.

Recoup Your Investment in Only 132 Years!

One does not need to be a Brookings Institute scholar like Mr. Sandalow, specializing in “oil dependence, electric vehicles, and climate change”, to see why no one will willingly purchase an all-electric car, much less the one million that President Obama wants on the nation’s highways in five years. (Call me cynical, but this number does not sound as if it were the result of a scientific analysis either.) First of all the cost of anything is that which is foregone by the purchase. In other words, when we buy something, we cannot spend this money on other things. That is what our cost is. In the case of Mr. Sandalow, his $9,000 investment cost him 3,000 gallons of gasoline at the current price of roughly $3 per gallon. Assuming Mr. Sandalow's Toyota Prius gets only 20 miles per gallon, he could have driven his car for 60,000 miles. Since his commute is 10 miles per day, Mr. Sandalow's conversion cost is the amount of gasoline he could have purchased to drive to work for 22.7 years. But that is not the only cost; the cost of electricity, which Mr. Sandalow estimates to be the equivalence of $.75 per gallon gasoline, has yet to be considered. This expense adds an additional $2,250 to his commute. (60,000 miles divided by 20 miles per gallon times $.75 = $2,250) Stated another way, he could have purchased another 750 gallons of gasoline and commuted to work for another 5.7 years, or 28.4 years total.

(By the way, there is nothing special about needing to fill up only once every month or two. Mr. Sandalow commutes for only 220 miles per month (10 miles per day times 22 work days per month). There is not a car in America that will not go further than that on a tank of gasoline. As coincidence would have it, my wife commutes ten miles per day to work in her SUV. She gets 16 miles per gallon in town. So she burns just shy of 14 gallons of gasoline per month commuting to work, well within her tank’s 25 gallon capacity.)

Now let’s move on to the $33,000 battery. Hold onto your hats! At $3 per gallon, Mr. Sandalow could have purchased 11,000 gallons of gasoline and driven his Toyota Prius for 220,000 miles. But, again, he would have had to buy electricity at the equivalence of $.75 per gallon, which would have cost him another $8,250. With this additional money he could have driven another 55,000 miles, or 275,000 miles total. This would allow our intrepid energy saver to drive to work for 104 years. (Of course, this cost assumes that one $33,000 battery will last for that many miles. If two batteries are required, you can double the cost and the years required to break even.)

So, by converting his car to a plug-in hybrid for $9,000, buying a yet-to-be produced 100 mile range battery for $33,000, and buying electricity for the equivalence of $.75 per gallon of gasoline, Mr. Sandalow could have purchased enough $3 per gallon gasoline to enable him to drive to work for 132 years!

Trust Only the Free Market

In conclusion, I have looked at the all-electric car calculation only from the side of the consumer. I have not touched upon the nation’s capacity to generate enough electricity to recharge those one million batteries so desired by President Obama. And one can merely speculate on whether producing this additional amount of electricity will cause more smokestack pollution than the tailpipe pollution it supposedly will prevent. Certainly this is not a debate in which Austrians would engage. As Ludwig von Mises makes clear in Human Action, chapter 8, the only basis of economic calculation is money prices via a free market. This does not mean that unlimited pollution from power plants or automobile tailpipes is permissible. Property rights and one’s health may not be abridged by another’s pollution. But it does mean that a basis already exists for deciding upon the wisdom of an all-electric car—the free market. Each man strives to improve his own condition by seeking the cooperation of others. Entrepreneurs who believe in the all-electric car are free to invest their own money and lobby investor capitalists for more. But right now the all-electric car appears to be a black hole for wasting more taxpayer money. We must disabuse ourselves of the propensity to believe that anything can be accomplished as long as government throws enough money at it. We have been down this road before with the fast breeder nuclear reactor that was supposed to produce more fuel than it consumed. Billions was wasted. We seem to be doing the same thing today with wind and solar power, too. There may be an economically rational niche for these energy technologies, but only the free market will give us the answer.

My Letter to the Philadelphia Inquirer re: the all-electric car

From: patrickbarron@msn.com
To: inquirer.letters@phillynews.com
Subject: "Do the Math" to Reveal Faulty Logic behind the Electric Car
Date: Sun, 5 Sep 2010 10:10:17 -0400

Re: "Leading the Charge", Business Section for Saturday, September 4, 2010

Dear Sirs:
One need only a grade school knowledge of mathematics to understand why the electric car is not commercially feasible at this time. Take your article, Leading the Charge, about Mr. David Sandalow, a U.S. Department of Energy assistant secretary and an avid advocate for the all-electric car. He has converted his Toyota Prius into an all-electric car at the cost of $9,000. He travels five miles to work each day (a ten mile round trip) and needs to refuel only "about once every month or two", but his car needs to recharge after only 30 miles of travel. He estimates that his electricity cost is equivalent to buying gasoline at $.75 per gallon. He is enthusiastic in advocating that the government pursue developing a battery that will allow 100 miles between rechargings. The cost of such a battery is estimated by the government to be around $33,000 per battery. (Government subsidies do not lower costs; they only change who pays. So it is disingenuous to say that government subsidies will lower the cost of such a battery.)

OK, let's do the math, and one does not need to be a Brookings Institute scholar like Mr. Sandalow, specializing in energy, to see why no one will willingly purchase an all-electric car. First of all the cost of anything is that which is foregone by the purchase. In other words, when we buy something, we do not spend this money on other things. That is what our cost is. In the case of Mr. Sandalow, his $9,000 investment cost him 3,000 gallons of gasoline at the current price of roughly $3 per gallon. Assuming Mr. Sandalow's Toyota Prius gets only 20 miles per gallon, he could have driven his car for 60,000 miles. Since his commute is 10 miles per day, Mr. Sandalow's conversion cost is the amount of gasoline he could have purchased to drive to work for 22.7 years. But, Mr. Sandalow's electric cost of $.75 per gallon has yet to be considered. This expense adds an additional $2,250 to his commute. Stated another way, he could have purchased another 750 gallons of gasoline and commuted to work for another 5.7 years, or 28.4 years total.

Now lets move on to the $33,000 battery. Hold onto your hats! At $3 per gallon, Mr. Sandalow could have purchased 11,000 gallons of gasoline and driven his Toyota Prius for 220,000 miles. But, again, he would have had to buy electricity at the equivalence of $.75 per gallon, which would have cost him another $8,250. With this additional money he could have driven another 55,000 miles, or 275,000 miles total. Of course, this cost assumes that one $33,000 battery will last for that many miles.

Now, how many want to buy an all-electric car? If you raised your hand, please return your grade school diploma.


Patrick Barron

Predicting the Price Level

A key disagreement between the Austrian economists and Keynesian economists is over the consequences of expanding the money supply. Keynesians claim that increasing the money supply will cause a beneficial increase in economic activity, whereas Austrians claim that increases in the money supply cause all manner of bad consequences, one of which is the lowering of the purchasing power of all money currently in circulation. The most visible sign of such loss of purchasing power is a general rise in the price level. Therefore, it is important that the Austrians answer the Keynesians who say that the Austrian monetary theory is wrong, because the government’s pump priming, trillion dollar stimulus spending and the Fed’s massive asset purchases have not caused runaway price inflation. In this essay I will answer this criticism by explaining the fundamental forces at work to explain the relationship between the money supply and the price level and the forces of government intervention that make short term price level predictions impossible.

The Quantity Theory of Money

At the foundation of our understanding of money and prices resides the quantity theory of money. At this most basic level it is axiomatic that the price level is the intersection of the quantity of goods for sale on the market and the amount of money available to purchase these goods. Prices can rise for only two reasons. One, the quantity of money rises faster than the quantity of goods for sale. Two, the quantity of goods for sale drops faster than the quantity of money. Of course the reverse is true about a falling price level. Prices can fall for only two reasons. One, the quantity of money falls faster than the quantity of goods for sale. Two, the quantity of goods rises faster than the quantity of money.

Let’s use a simple example. Assume that there is only one commodity for sale in the economy. One hundred units of this commodity are produced. The money supply consists of one thousand units of currency; we’ll use dollars as our money supply unit. The only price that will clear the market of all goods offered for sale is ten dollars per unit. ($1,000 divided by 100 units) Let us suppose that there is a production improvement that allows the market to produce two hundred units of the same commodity. Then the market-clearing price will be five dollars per unit. ($1,000 divided by 200 units) Likewise, let us assume that the money supply increases to two thousand dollars while the ability of the market to produce goods remains the same at one hundred units. Then the market-clearing price will be twenty dollars per unit. ($2,000 divided by 100 units) From this simple example one can clearly see that, if we admit that the U.S. economy produced more goods today than it did twenty years ago, then the primary reason that prices have not fallen is that the money supply increased concomitantly. Likewise, if prices are higher now than they were twenty years ago and real economic output is essentially the same, then the culprit must be an increase in the money supply. But most of us grant that the U.S. economy produces more “stuff” than twenty years ago. So if the price level is higher, the only explanation is an increase in the money supply. Had the money supply remained stable, the only way that the market could have cleared the larger supply of goods would have been for prices to fall.

(Since 1990 M2 has increased by a factor of 2.62 while nominal GNP has increased by 2.57, which leads one to the conclusion that the economy has not really grown at all in terms of real goods and services in two decades. All of the increase in GNP can be attributed to higher nominal prices caused by an increase in the money supply.)


The Three Uses of Money

The quantity theory of money is at the foundation of understanding money and prices, and it does explain long-term trends. But other factors operating within this foundational theory determine market prices in the short-term. One of those factors is an explanation of the purposes to which money can be used.

There are three and only three uses for money—to hold (hoard), spend, and invest. Of the three, only the combined size of the spend-and-invest components determines the price level; i.e., spending and investing are those components of the money supply that are brought to market to purchase goods available for sale. As the total quantity of spending and investing increase in relation to the quantity of goods and services brought to market, prices will increase. If either or both of these components decrease, prices will decrease. Importantly, if the money supply increases and all of the increase goes into hoarding, the price level will remain the same.

Suppose that the Fed printed enough paper money to give everyone in America one million dollars. Since there are 300 million Americans, the money supply would increase by 300 trillion dollars! Surely that would trigger higher prices! But let us also assume that every American took the money and placed it under his mattress. He did not spend one cent. What would happen? Well, the money supply would increase by 300 trillion dollars, but the price level would remain the same. All the new money would have gone into hoarding and would have no impact on prices.

An Ever-Changing Money Supply

So far our discussion of how money affects prices assumes that there is no intervention by an outside, coercive agent that attempts to manipulate both the total size of the money supply and the three uses of money. Unfortunately that is not the case. The government intervenes regularly and inconsistently in monetary matters, making it almost impossible to point to one or two factors that will have the most impact on prices.

The most important interventionist governmental body is the Federal Reserve Bank, our central bank, which almost always attempts to expand the money supply. It “adds liquidity”, mostly by increasing bank excess reserves. Right behind the Fed is the Treasury Department, which spends the money. Both attempt in various ways to stimulate the economy by ensuring that any increases in money go into the spending and investing buckets and not into the holding/hoarding bucket. Currently the Fed and the government want all of the money to go into the spending bucket exclusively, so that the GDP numbers will rise. You see, the government measures the size of our economy by how much we spend, so it tries to manipulate this number in a variety of ways. The “cash for clunkers” program is a case in point. If nothing else causes one to question this whole paradigm, the government’s claim that destroying still useful, but older vehicles adds to our economic well being should end such naiveté.


It is beyond the scope of this article to explain the many ways that the Fed increases excess reserves and the effect this increase can have over time on the size of the money supply. Let us just say that although the Fed has less than perfect control over the money supply in the short run (and the short run can be years long), it is the size of total reserves and the reserve requirements that establish the outside parameters of the money supply. Typically bank excess reserves are around only $2 billion or less, not a great deal in an economy the size of ours. As of July 28, 2010 bank excess reserves stood at $1.012 trillion dollars! Since we have a fractional reserve banking system, the potential exists for banks to expand our money supply by many multiples of these excess reserves.

Conflicting Government Interventions

But it gets even more complicated! While one department of the Fed tries to expand the money supply, there is another whose actions prevent it—the bank examining force. As the left hand of the Fed hands out reserves to all comers, the right hand ensures that those reserves will not be converted into money via lending. In fact the right hand of the Fed--and other bank regulatory agencies, such as the FDIC--currently exercise a deflationary impact on the money supply. These agencies are forcing banks to charge off suspect loans against capital. When a bank’s capital ratio falls below that required by bank regulations, the bank has only two choices. It can attempt to raise capital, a difficult thing to do these days, or it can reduce the size of its balance sheet by reducing loans outstanding. Loan reduction has a deflationary effect on the money supply.

Add to this structural issue the fact that there really aren’t many good loans out there, which would create new money as desired by the Fed’s left hand, and you can see why all that additional liquidity has yet to reach its potential as the basis of new money. The key word here is “yet”. The potential for a massive increase in the money supply exists, however.

The Risk of Hyperinflation

Now we get a glimpse of what has been happening. The Fed has been adding liquidity mostly in the form of excess reserves. As yet these excess reserves have not been employed by the banking system to support an increase in the money supply via new lending...the bank examining force has blocked this route. The money that has found its way into peoples’ pockets has stayed in peoples’ pockets--it has been hoarded. There is no way to predict the end to hoarding, the end to bank recapitalization, and the end to bank loan problems. But when these deflationary factors do end, American prices will rise as the hoarded money and the increased money created by increased lending flow into spending and/or investing. At that point we will enter what Ludwig von Mises called the “danger zone”. No one will wish to hold depreciating dollars; they will be spent as rapidly as possible, creating the real possibility of what Mises called the “crack-up boom”. Despite the tough talk by Fed Chairman Bernanke, the Fed will be powerless to prevent this debacle. Money will become worthless.