Stable Money Required for Economic Progress

It now seems certain that the Fed will embark upon a new, second round of money expansion, called Quantitative Easing, or QE2 for short. During QE1 the Fed expanded its balance sheet by roughly $1.7 trillion by purchasing assets, mostly government bonds, in order to lower interest rates and spur economic recovery. At least this was the Fed’s goal. It did lower the interest rate for short term rates to as close to zero as can be expected; now it will target longer term rates by offering a higher price for these instruments, thusly, driving down their interest rate. The Fed fears deflation, which it defines as a general decrease in prices, and is on record as desiring to instill at least a two-percent inflation rate, which it defines as a general increase in prices. The Fed policy makers believe that a two-percent inflation rate is what is necessary for the American economy to achieve full employment, which is one of the Fed’s overall policy goals. The other policy goal is stable prices. In typical government Newspeak the Fed boldfacedly asserts that a two-percent increase in prices is the same as stable prices. I guess it all depends upon one’s definition of “stable”.

There is little doubt that the Fed will be just as successful in driving down long-term rates as it has been in driving down short-term rates, but neither of these actions will help the economy. On the contrary, these actions will harm the economy. What the Fed should pursue exclusively is a stable supply of money, which is not the same as stable prices. The Fed should cease its sales and purchases of assets. Furthermore, it should end its interference into any money markets, such as the Federal Funds market for overnight sales and purchases of bank reserves. In other words, the Fed should stand aside as an active participant in the nation’s economy and act solely as a protector of the supply of money.

In the interest of space and the reader’s patience, I will explain very briefly why a stable money supply is desirable.

Money is a universally accepted medium of indirect exchange, meaning that people hold money only in order to expend it at some later time for a good or services that they really desire. (It is not true that people have an unlimited desire for money; they have an unlimited desire for the things that money will purchase.) As such, the relative demand for goods and services is expressed in terms of money, the universally accepted medium of exchange. But the exchange ratio between money and all individual goods is constantly in flux. Some goods become cheaper as their supply expands and/or demand for them drops. The opposite is true when a good’s money price rises. In an expanding economy, there is a general tendency for most goods to fall in terms of money, as long as the supply of money is held stable. There is no adverse economic consequence to such a situation; that is, in an environment of generally falling prices businesses will make money, pay back loans, and expand operations. It is not true that falling prices are a mark of a failing economy.

In order to keep prices from falling in a generally expanding economy that produces more goods and services, the supply of money must increase. This happened in the 1920’s and led to the 1929 stock market crash. As Murray N. Rothbard explains in America’s Great Depression, the 1920’s were a period of rapid productivity increases due to such factors as the expansion of the nation’s electrical grid and the introduction of the assembly line. But the barely decade-old Fed--which was under the sway of Irving Fisher, a very influential economist who held that price stability was important--increased the money supply throughout the decade to offset the tendency of prices to fall.

This interference in monetary affairs sent false price signals to entrepreneurs that more resources were available for long-term investment than really was the case. The structure of production was altered in such a way that not all enterprises could be completed profitably. The nation was not saving as much as the lower interest rate would suggest. The Fed had enticed businessmen to begin investments that were contrary to the wishes of the consumer as expressed by his real spending patterns. He wasn’t saving enough. Eventually the reality of the situation became apparent and the stock market crashed. But rather than allow the economy to shed the malinvestment, the government undertook a decade’s long experiment in even more intervention in a futile attempt to rekindle the false boom. Only the exigencies of World War II convinced government to end the worst of the Hoover/New Deal policies in order to ramp up war production.

So, we see that it was fiat money expansion that caused the stock market to crash at the end of the 1920’s. The general price level had indeed remained stable throughout the Roaring Twenties, but we now know that it should have fallen. A generally falling price level would have prevented the malinvestment of business, for interest rates would have reflected the true state of the cost of savings for long term capital investment. The structure of production would not have been skewed, which later required its wholesale liquidation.

Today’s Fed is contemplating inflicting an even worse situation on the nation—a positive inflation rate. By driving down long term rates it hopes to entice businessmen to alter the structure of production in favor of longer-term investments. At the same time it is trying to spur consumer spending. These are completely contradictory goals and cannot both be achieved. If the consumer spends more, he saves less. In a free market, this will drive up interest rates to reflect the consumer’s preference for goods in the immediate term rather than in the long term. If the consumer saved more, the additional supply of funds would drive down the interest rate and make longer term capital investment feasible. We cannot have it both ways. Furthermore, the Fed does not know the proper level of interest rates, because it cannot possibly know the consumer’s propensity to spend and save…nor need it know. If the Fed does its only job properly, which is keeping the money supply stable, the aggregate actions of all consumers will determine the interest rates for all maturities.

In conclusion, the Fed should not pursue any interest rate strategy. Rather, it should keep the money supply stable so that the market will allocate savings to establish the structure of production in accordance with the desires of the consumer. But current Fed policy is a replay of its own failed strategy of the 1920’s and ‘30’s, except it is a policy on steroids. The result will be more malinvestment, more bankruptcies, more unemployment, and general impoverishment of the nation.

My Letter to National Review re: The Bender is Over

From: patrickbarron@msn.com
To: letters@nationalreview.com
Subject: Why "The Bender Is Over"
Date: Fri, 29 Oct 2010 14:10:04 -0400

Re: The Bender is Over, by Ramesh Ponnuru and Richard Lowry

Dear Sirs:
As much as I enjoyed and appreciated Messrs Ponnuru and Lowry's political insight into the president's falling ratings, I kept waiting for something of more substance to explain the phenomenon beyond "the public really is more conservative that we all thought". Why is the public more conservative than we all thought? I think the answer is clear--socialism just doesn't work and everyone knows it. The lesson of the fall of the Soviet empire has not been lost on free peoples everywhere, especially in the U.S. We just won't fall for the shyster's line anymore that we all can live at one another's expense.

Patrick Barron

My Letter to the WSJ re: A Carpenter With Only One Tool

From: patrickbarron@msn.com
To: wsj.ltrs@wsj.com
Subject: Carpenter with only one tool
Date: Wed, 27 Oct 2010 15:51:21 -0400

Re: Fed Gears Up for Stimulus

Dear Sirs:
The Fed is like the carpenter with only one tool, a hammer, who sees every problem as needing a good pounding. The Fed's only tool is the monetary printing press, so it sees every economic problem as a lack of money. According to your report, "The Fed's aim is to drive up the prices of long-term bonds, which in turn would push down long-term interest rates." This statement, which undoubtedly is true, illustrates perfectly the Fed's chief policy error. It has no regard for the role that savings plays in an economy. It is savings that the economy needs in order to rebuild the malinvestment of the lost decade of this new millennium. Savings is the fuel of capital investment. Without savings a modern economy will fail to replenish its capital stock. Ours is being consumed in an orgy of wasted government stimulus spending. Already the poor saver is getting next to nothing for his money, and Bernanke would drive him completely out of the market. If he succeeds, and it seems likely that he will, our economy will resemble that of Argentina in a few years--a once prosperous country driven to default, hyperinflation, widespread poverty, and political tyranny.

Patrick Barron

My Letter to the WSJ re: A Madman Wants to Rebalance the World's Economy

From: patrickbarron@msn.com
To: wsj.ltrs@wsj.com
Subject: A Madman Thinks He Can Rebalance the World's Economy
Date: Fri, 22 Oct 2010 15:40:12 -0400

re: Geithner's Goal: Rebalance the World's Economy

Dear Sirs:
Interviewing Timorthy Geithner must be a frightening experience, for it must soon become apparent that the man is stark raving mad. The very idea that he and his fellow bureaucrats in other countries believe that they can fathom the essence of the world's economy, decide which countries should be allowed to grow and to what extent, decide the statistical measures that would indicate which countries' growth rates are sustainable and which are not is patently preposterous. Countries which adopt capitalism and grant basic political and economic freedoms, most importantly the protection of property rights, will grow much faster than those who adopt less favorable policies. Would Mr. Geithner and his fellow madmen deem these countries to be pariahs and erect trade and capital barriers to prevent them from becoming more prosperous? Apparently the success of a free people would be an embarrassment to big government madmen such as Mr. Geithner; therefore, the rest of the world must mobilize to stop them.


Patrick Barron

My Letter to the WSJ re: China Raises Interest Rates

From: patrickbarron@msn.com
To: wsj.ltrs@wsj.com
Subject: Re: China Raises Interest Rates
Date: Tue, 19 Oct 2010 09:23:57 -0400

Re: China Raises Interest Rates

Dear Sirs:
Economic data from China is always suspect. I doubt that China's inflation rate, as measured by its CPI, is below 4% as officially reported. By holding its currency cheap China has subsidized its export industries at the expense of higher prices in the rest of its economy. This classic mercantilist policy was bound to fail. If the Bank of China ceased its currency interventions, there is little doubt that China's interest rates would go much higher, causing a necessary restructuring of China's economy and an end to price and asset inflation. This move is always resisted by powerful interests who have become rich due only to government manipulation of the currency and other interventions. It is the same everywhere in the world. The first nations to abandon mercantilism will reap the gains of capital inflows. It appears that China has learned this lesson.


Patrick Barron

My Letter to the WSJ re: The Myth of Full Employment via Money Expansion

From: patrickbarron@msn.com
To: wsj.ltrs@wsj.com
CC: jon.hilsenrath@wsj.com
Subject: The Myth of Full Employment via Money Expansion
Date: Fri, 15 Oct 2010 10:42:33 -0400

Dear Sirs:
Fed Chairman Ben Bernanke is confused about the money supply, the price level, and the benefits of manipulating both to achieve full employment. In his speech at the "Low-Inflation Environment Conference", he states that it is the Fed's intention to promote price stability and full employment via a two percent general price inflation rate. So, which does he want--price stability or two percent price inflation? And how exactly will either promote full employment? The simple and well-know "rule of 70" reminds us that prices will double in the number of years equal to 70 divided by the inflation rate. So at a two percent price inflation rate, the price level will double in thirty-five years. That is hardly price stability. Plus, the only way the general price level could remain the same in a growing economy is for the money supply to increase in proportion to the increase in production, causing repeated boom/bust business cycles. In a stable money environment prices would fall as production increases, a boon to every level of society. Sixty years ago the great German economist Wilhelm Ropke demolished the fallacy that full employment could be achieved via money expansion. I suggest to your readers his excellent essay on the subject, "The Economics of Full Employment", found in The Critics of Keynesian Economics.

Patrick Barron

My Letter to the WSJ re: Dollar Slide

From: patrickbarron@msn.com
To: andrewj.johnson@dowjones.com; wsj.ltrs@wsj.com
Subject: Dollar slide caused by stimulus
Date: Thu, 14 Oct 2010 15:39:02 -0400

Dear Mr. Johnson,
You led your article today about the dollar slide with this statement:


"The dollar fell sharply against a range of currencies Thursday as prospects for Asian economic growth contrasted with the likely need for more stimulus in the U.S."

The U.S. does not need more stimulus. It needs more savings. Stimulus merely consumes capital and puts the U.S. further into debt, contributing to the dollar's slide. Let me recommend that you acquaint yourself with the Austrian school of economics. Go to www.mises.org and search on monetary policy to learn how markets really work. As Ludwig von Mise wrote many decades ago, all exchange rates are set in the market by the relative purchasing power of the respective currencies. The dollar's purchasing power is being eroded with the threat--no, let us say "promise"--of further erosions. This threat to the U.S. economy is as serious as it is unnecessary.

Patrick Barron