How Money Has Changed, and Why It Matters

Recurring economic crises are nothing but the consequences of attempts … to stimulate economic activity by means of additional credit.
          —Ludwig von Mises, preface to the 1934 English edition of The Theory of Money and Credit

Will the expansionary monetary policies of central banks in the United States, in Europe, in the United Kingdom and in Japan lead the global economy into another period of economic ruin? If some economic pundits are right, asset price bubbles and then their collapse are on the way. For an Austrian economist there is no other conclusion to draw. At question is whether economic prophecies of ruin are prescient or mistaken.

At one level the outcome will depend on the finesse of central banks. But it will also point to which of two schools of free-market economics has the best script. The interventionist school (Keynesian economics) has already been relegated to the scrapheap. The aftermath of the global financial crisis laid bare its poverty. As Galbraith might have put it if he hadn’t himself been a Keynesian: it was just another conventional wisdom inconvenienced and eventually undone by experience. Of course, this won’t ever be conceded by the faithful. But the facts speak for themselves.

Massive government stimulus spending has dislocated economies, slowed recovery, and resulted in onerous and burdensome public debt. This would have come as no surprise to any economist predating the Keynesian revolution. Equally it is an entirely predictable outcome for modern-day free-market economists, whether they trace their theoretical lineage from the classical economics of the nineteenth century (fathered by Adam Smith’s Wealth of Nations in 1776) or from Austrian economics (fathered by Carl Menger’s Grundsätze in 1871).

This might suggest that free-market economists are at one. However, classically-inspired economists (who I will call “conservative economists” for want of a more felicitous term) are not simply Austrian economists without knickerbockers, as the saying goes. In fact, there is serious division in the free-market camp. I am not referring to esoteric theoretical differences between the two schools of thought, which are best explored in academia. My concentration is narrowly focused on the area of difference that matters for macroeconomic policy—their respective approaches to money and monetary policy.

I reviewed a brilliant and entertaining book published in 2009 by Austrian economist Tom Woods. Full of praise for Meltdown, I nevertheless added a rider that I parted company with Woods on the need for central banks to ease monetary policy in recessionary times. Woods’s position was true to his Austrian heritage. Monetary policy largesse on the part of Alan Greenspan had been instrumental in causing the global financial crisis and therefore it was “crazy”, he argued, to think that yet more largesse would help solve it. In other words, how can the cause of the disease be its cure?

Later I reflected on the incongruity of praising Woods’s book while at the same time taking issue with its central thesis. It reminded me of Keynes’s curious correspondence with Hayek in which he said he agreed with almost everything in The Road to Serfdom yet thought more economic planning rather than less was needed. I assume that had Hayek scratching his head. Essentially Woods is either right about monetary policy, or his economics and his book, however brilliant and entertaining, are of limited use in informing macroeconomic policy in current circumstances.

To Austrian economists, excess monetary growth is the key cause of both price inflation and of pronounced and debilitating cyclical fluctuations in economic activity. That is why anchoring the money supply to a stock of gold is a core aspiration. It would, they argue, bring price stability and more stable economic progress.

As to the first claimed effect of unshackling money from gold there can be little argument. The replacement of commoditised money with fiat money in the twentieth century (money of no intrinsic value or convertibility but given sole status as legal tender by government) has brought about a profound decline in the value of “a dollar”. In fact, it has brought it to less than one cent now when measured from 1914. Reinhart and Rogoff (in This Time is Different) estimate that median global inflation was 5 per cent per annum between 1914 and 2006 compared with 0.5 to 0.7 per cent from 1500 to 1913. Unsurprisingly, governments with power to create money out of thin air have endemically overspent. And money growing faster than real production inevitably results in a progressive decline in the worth of the currency; in other words, in inflation.

The second claimed effect of unshackling money from gold is not quite so straightforward or non-controversial. Economic and financial crises are not a recent phenomenon. Reinhart and Rogoff describe “eight centuries of financial folly”. However, Austrian economists would correctly point out that currency debasement (such as lowering the silver content of coins) was a regular practice of sovereigns with denuded treasuries long before the development of fiat money. And, in one form or another, it was always at work in the most serious of crises.

I don’t believe that there is a sliver of gap between Austrian and conservative economists in taking the view that excessive monetary expansion has played an instrumental part in every serious financial crisis, whatever century is chosen. The gap in thinking begins to emerge, particularly in the context of the evolving monetary system of the last 100 years, over the degree to which excessive monetary expansion is partly endogenous to capitalism rather than being wholly exogenous. Please don’t stop reading. I will explain.

Money—the thing people will universally accept in exchange for goods and services—used to be gold and silver coins and subsequently notes and coins of no intrinsic value. Now money mostly consists of bank deposits. Currency (notes and coins) form only a small part of the money supply. In Australia, currency is just 20 per cent of narrowly defined money (M1), which encompasses currency and bank demand deposits, and less than 4 per cent of M3, which includes demand and term deposits at all deposit-taking institutions.

Most money is generated by bank lending. When a bank takes in a deposit it places a small portion in reserve with the central bank and can lend out the rest. This lending finds its way back into one bank or another as a deposit; a high proportion of which can be lent out again, and so on. This is called the fractional reserve system. If a high proportion of depositors want their money back at the same time, banks are in considerable trouble. They will knock on the door of their central bank for help.

Austrian economists have central banks in their sights as part, as Woods says, of “getting the government out of the money business”. Central banks underwrite and power the fractional reserve system which allows banks to create money. They do this in three ways. First, they provide a backstop for banks facing a run on their deposits. Second, they provide the wherewithal for banks to increase their lending and deposit creation by buying up securities issued by spendthrift governments. Third, they manipulate interest rates lower to encourage borrowing when economies are recessed. Nothing that Woods and other Austrian economists say about the role of central banks and the fractional reserve system is wrong. But is it complete?

Austrian economists position themselves as if credit creation through financial intermediation is an exogenous variable imposed on free markets which otherwise would operate much more benignly. Woods notes that “Roman law, one of the building blocks of Western civilisation, distinguished between time and demand deposits, and absolutely forbade the lending out of demand deposits”. This is instructive. Let’s leave aside the nodding imprimatur that Woods seems to give to official interference in market processes—hardly an Austrian libertarian position to take. What it implies is that market processes, even in those early Roman days, endogenously created credit on flimsy foundations. Else why the law? There is no doubt that rampant credit creation contributes mightily to crises. But the question is whether in part such credit creation is innate to the operation of free markets and is a price that must be paid if they are to flourish and make us all more prosperous.

The proof of the pudding has been in the eating. Capitalist free-market economies have had regular and frequent bouts of debilitating volatility and have suffered increased regulation from poorly schooled and opportunistic politicians as a result. They have still continued to make the world richer beyond the wildest dreams of our forebears. Capitalism needs credit to function. Imagine a world where deposits in gold are kept in vaults only to be lent out provided borrowers agree to cart back the gold at the depositors’ pleasure. Is this a caricature of the Austrian position? Yes it is. But consider what needs to happen to make capitalism work.

Capitalism has a number of essential and complementary components, assuming as a backdrop the rule of law and property rights. It has entrepreneurs with imagination and ideas and the courage to bring businesses to life. It has a workforce adequately equipped to operate the businesses. It has financial capital at the disposal of entrepreneurs without which nothing would happen. Financial capital is supplied by savers. Savings need to find their way to entrepreneurs. It is no good having spare coconuts rotting on a desert island when for want of those coconuts an entrepreneurial islander is deprived of the capacity to build a bigger boat to catch more fish. Credit creation by banks funnels savings to entrepreneurs. It has been an indispensable part of the flowering of modern-day capitalism which otherwise would have remained relatively stunted. Sure, it funnels credit for wasteful purposes and at times creates more than is desirable. Economic life is an imprecise business.

Bank credit and money creation is a singular success of capitalism, not a flaw. Money has gone through three, not two iterations. Fiat money followed commodity money. Now private money—bank deposits primarily created by consent and trust among freely acting individuals—is the predominant money. Why do we accept a bank deposit as discharging an obligation? A bank deposit is not a government promise to pay. It is the liability of a corporation. We accept it because experience has told us that it as good as currency. At the same time, we know that banks could not redeem all or most of their deposits in any short period of time. Confidence is the key. Central banks play a vital role in helping to instil confidence by standing behind banks. They often pursue mistaken policies—Austrian economists are right about that. But they are a necessary part of ensuring that capitalism is adequately funded when bank deposits—effectively private money—have become the dominant form of money.

It is reasonably clear that Greenspan presided over mistaken policies in the years preceding the global financial crisis. The fed funds rate was brought down from 6.5 per cent at the end of 2000 to as low as 1.0 per cent in mid-2003 and did not get back to a neutral rate of 4.5 to 5.0 per cent until 2006. Other important factors were at work in creating the crisis but it is hard to think that it would have been so severe without Greenspan. To return to the start, the question is whether the current expansionary policies being pursued by central banks will contribute to a new crisis. Are Austrian economists right? Will it all end in tears?

Interest rates across the length of the yield curve—short rates and long—are being held down by central banks. This is being accomplished by operating in the market to keep overnight inter-bank lending rates at extremely low levels, and by buying long-dated securities to keep their price up and yield down. This latter activity, falling under the old banner of “open market operations”, is now called quantitative easing (QE); as though there were any other kind of easing. In fact, central banks have to buy securities to bring rates down. There is no other way. Supply and demand hold sway, as they always do. However, the sheer size of the current open-market operations of numbers of central banks separates them from the norm. Understandably this is causing anxiety. To get a balanced handle on what is happening it is useful to separate the money side of the economy from the real side.

On the money side, QE is often loosely and misleadingly referred to as “printing money”. It is not meant to be taken literally, of course. Nevertheless it gives the wrong impression that price inflation of goods, services and physical assets is around the corner. It conjures images of German housewives in the 1920s pushing wheelbarrows full of marks to buy a loaf of bread or French peasants in the late eighteenth century using worthless paper assignats to light their pipes. To be clear, there is no untoward printing going on. The supply of currency is not growing rapidly. We no longer live in cash economies. We use bank deposits.

When, as part of QE, central banks buy securities from non-banks, bank deposits increase, as correspondingly does the money supply. However, this increase will be limited unless there is an accompanying upsurge in bank lending based on those deposits. When central banks buy long-dated securities from banks there is no increase in the money supply. In the USA, for example, banks have increased their holdings of deposits with the Fed and of short-dated treasury bills. They have built a store of highly liquid assets, not a store of illiquid loan assets that would have significantly increased the money supply. The money supply surges when bank lending surges. The reason this has not yet occurred to any great extent in the USA or elsewhere in the West is because there has been a shortage of lendable propositions in relatively moribund economies.

OECD figures show “broad money” (largely currency plus bank demand and term deposits) growing at a relatively modest 6 per cent in the USA between the fourth quarters of 2012 and 2013, at less than 4 per cent in the UK, 3.5 per cent in Japan, and 3.5 per cent (third to third quarter) in European OECD countries. Mind you, this is no time for central banks to relax. There are early warning signs of problems to come unless action is taken at the right time to tighten things up. Narrowly defined money (currency plus demand deposits) appears recently to be gathering some pace, as does bank lending. In the USA, for example, bank lending for commercial real estate and for commercial and industrial purposes kicked up quite strongly in the three months to the end of February 2014.

So much for the money side. On the real side unemployment remains high and growth sluggish across Western economies years after the recession apparently ended. To use Keynesian nomenclature, the risk-adjusted investment return many entrepreneurs and businesses expect from new investment falls short of the interest cost of their borrowings. What are governments to do when they no longer suffer from the delusion that more Keynesian stimulus spending will help? The answer is to have central banks reduce interest borrowing costs as much as possible and hope, at the same time, that cost-cutting and improvements in business processes will lift confidence and expected returns and, finally, trigger increased investment.

Reducing borrowing costs has its direct initial counterpart in rising prices of financial assets—bonds and shares. That is the intention. It is bound to happen. It is an asset bubble. But here is where a distinction between the real side of the economy and the money side is critical to understanding the state of economic affairs. The asset bubble is a financial asset bubble, which may or may not burst or slowly deflate. The important point is that it is not the kind of bubble that heralds a recession.

Before the global financial crisis there was an asset bubble that mattered. It was the kind that showed itself in inflated prices of real physical assets—in that case of residential real estate in the United States. When that kind of bubble bursts a recession usually follows because we are dealing with the misallocation of real resources, not with mispriced pieces of paper. Western economies are not at that stage, but it’s best not to let them get too close. Alarm bells should go off when bank lending and the growth in money supply begin to gather sustained pace and the prices of long-life physical assets, particularly of real estate of one kind or another, start rising steeply.

Austrian economists are mistaken to a degree, I think, because they are mentally attuned to an age of fiat money. We are in an age of private money—bank deposits. Reckless printing of paper money is a relic of the distant past—Zimbabwe under Mugabe aside. But they are mistaken mainly, I think, because they understate the extent to which “excessive” private money creation is a creature of capitalism rather than being its externally-driven wire-puller. Despite all the mammoth easing efforts of central banks, money supplies are not as yet growing at particularly high rates in the United States, in the UK, in Europe or in Japan. Of course, QE is building the banks’ reserves and stock of highly liquid assets, which gives them enormous scope to extend credit if the demand arises; and thereby greatly expand the money supply. Undoubtedly this has the potential of causing great harm; but not the inevitability. It remains to be seen whether central banks will have both the finesse and will to act pre-emptively to dampen monetary expansion before it runs too far by turning QE into QT (quantitative tightening), that is, by selling securities rather than buying them.

In understanding that free-market capitalism is the key to economic prosperity, conservative and Austrian economists have much more to draw them together than pull them apart. At the same time, they do have a materially different view about money. This can be put in no starker relief than during a recession whose origins can be traced, as most can to some extent, to excessive monetary growth presided over by lax central banking. At this point do you think central banks should ease monetary policy or not?

The Austrian point of view is clear. There are no circumstances in which central banks should intervene to force interest rates down. The conservative view is more nuanced and geared pragmatically to prevailing circumstances. It is acknowledged that nominal interest rates will naturally fall during recessions and lay the basis for eventual recovery. The problem is that when recessions are deep a deflationary outlook can easily develop. This pushes up real (inflation-adjusted) interest rates. In turn, this can slow, stall or prevent recovery. Recessions bring economic hardship and social distress. The pragmatic view therefore favours central banks speeding recovery by putting additional downward pressure on interest rates.

Putting downward pressure on interest rates is a world away from distorting and value-destroying stimulus spending, which artificially inflates particular components of demand. Monetary easing operates neutrally on the value-creating supply side of the economy by encouraging businesses to borrow, to invest, to make things, and employ people. There is a persuasive rationale for its application until the economy gets back onto an even keel. In other words, the cause of the disease can indeed be its cure provided the dose is properly calibrated and discontinued at the appropriate time.

What this says about the current situation is that it need not end in tears if central banks pull back on monetary easing as they see credit growing and their economies gathering pace. The financial asset bubble cannot be allowed to morph into a real asset bubble. The tapering of QE in the United States is therefore a good sign despite the overdone consternation it has caused and will no doubt continue to cause in financial markets and among some European and other governments.