John C. Williams, president and CEO of the Federal Reserve Bank of San Francisco, delivered an address this summer to the American Economic Association’s National Conference on Teaching Economics and Research in Education. He titled it “Economics Instruction and the Brave New World of Economic Policy.”
One wonders whether Williams ever has read Aldous Huxley’s chilling book warning of the threat to individual freedom by a tyrannical one-world state. If he had, I doubt he would have included “Brave New World” in the title of his speech.
The speech was an admission the Fed’s monetary theories have failed, that the Fed is experimenting with new ones, and that it wants academia to endorse its policy experiments and incorporate them into college curricula.
“We depend upon educators like you to explain how the Fed works and how our policies affect the economy. We all benefit when the public understands what we do and why, so we are very grateful for the work you do,” he said.
1950s vs. 2011
Williams launched into a rather disjointed defense of the reasons the Fed considered it necessary to employ new monetary policy tools. (Of the 12 policy tools on the Fed’s Web site, Williams proudly proclaimed nine of them did not exist four years ago.) In his own words: “How do 1950s theories of cash and checks apply in a world in which you and I can instantly take out a loan of several thousand dollars with the swipe of a card at the cash register?”
It is obvious Williams has never read Ludwig von Mises’ The Theory of Money and Credit. In Mises’ first great book he explains the differences between money and credit; thus, the name. Money represents final payment beyond which there is no recourse; credit must be satisfied via money. I’m certain Williams would be surprised to learn that in early 1950s America, credit was granted just as rapidly at some retail counters as it is today.
Back then it was common for housewives to buy groceries on credit. The neighborhood grocer recorded the housewife’s almost-daily purchases in a book kept under his counter. Housewives settled their grocery accounts after their husbands were paid, usually in cash, at the end of the week.
An Electronic Check
These credit transactions did not affect the money supply any more than do today’s credit card transactions. The debt card is simply “an electronic check”; it embodies all the legal risks and protections of a paper check. Paper checks have been around since long before 1950.
Next Williams bemoans the failure of some cherished monetary theories, such as the breakdown in the link between additional reserves and a growing money supply via the money multiplier. The volatility of the velocity of money gives him the vapors. Both theories assume there is a mathematical link between the quantity of reserves, the quantity of money, and GDP. The thinking is thus—increase reserves, observe an increase in money; increase money, observe an increase in GDP.
But according to Williams, “Despite a 200 percent increase in the monetary base—that is reserves plus currency—measures of the money supply have grown only moderately;… [The[ mechanical link between reserves, money supply, and ultimately inflation no longer holds.”
Driving down the interest rate hadn’t worked either: “model simulations recommended setting the Fed funds rate below zero.”
So, what to do? Quantitative easing! The Fed bought $1.7 trillion in assets (many of dubious value) starting in late 2008 and added an additional $600 billion by June of this year. According to Williams, this is working.
Dubious Definition of ‘Growth’
Embodied in Williams’s speech is the assumption that an increase in GDP represents an increase in economic output. That is why the Fed is unconcerned about inflation (what we Austrian-school economists call “rising prices”) and more concerned about deflation (what we Austrians call “falling prices”). If there really is some link between money and economic output via a money multiplier, then increasing money is as simple a way ever invented to bring on prosperity. By this reasoning, however, Zimbabwe was tremendously prosperous.
So if prices rise 5 percent and people are buying the same volume of goods and services, then according to the Fed the real economy improved 5 percent. If it doesn’t happen—that is, if measured GDP fails to increase 5 percent—then the government must deficit-spend, and the Fed must provide the funds at zero interest.
The Fed’s fixation with nominal GDP is the problem. As Jesus Huerta de Soto masterfully explains in Money, Bank Credit, and Economic Cycles, nominal GDP measures only final sales, and most sales are not final. Most are intermediate sales between companies. A growing economy in which people extend their time preference, save more, and consume less may actually record a falling GDP.
Furthermore, in a sound-money environment, GDP would be flat to perhaps slightly rising, because real money—that is, commodity money such as gold—increases slowly. Yet economies can boom with increased real production; prices fall, meaning an unchanged volume of money does more work.
But we see here the political problem for policymakers. Nowhere in this real world is there a need for a central bank manipulating money.
Patrick Barron ([email protected]) is president of PMG Consulting, LLC. He teaches at the Graduate School of Banking at the University of Wisconsin-Madison and at the University of Iowa.