Free Banking and the Optimum Quantity of Currency

How does the relationship between deflation and the optimal quantity of hand-to-hand currency apply to a regime of free banking?

Consider a free banking system with a limited number of large, nationally-branched banks. Each bank issues both deposits of various sorts and hand-to-hand currency. Assume that that the deposits pay interest and that the nominal interest rate on the hand-to-hand currency is zero.

A reduction in the expected inflation rate should reduce the interest rates on nonmonetary assets and the nominal interest rates banks pay on deposits. Both reduce the opportunity cost of holding zero nominal interest currency. Under normal conditions, the more important effect would be a shift out of deposits into currency. The currency deposit ratio would increase.

Unlike a regime with a government monopoly on currency issue, the banks simply change the composition of the liabilities they use to fund their asset portfolios. There is no need to shuffle assets between the Fed, the banks, and the nonbanking public. In a free banking system, much of what today counts as "vault cash" is unissued banknotes. These aren't bank assets or liabilities, and they have no yield that would impact bank profitability. Clearinghouse balances instead form the key part of reserves, and like bank deposits, nominal interest can be paid on these reserves.

There are no complications involving the time path of government seniorage, because a free banking system generates little or no seniorage revenue for the government. Instead, a decrease in the expected inflation rate and so the nominal interest rate on earning assets reduces the profits banks earn by borrowing through the issue of currency for which they pay a zero nominal interest rate.

It is natural to assume that banks can profit by borrowing at a zero nominal interest rate and holding earning assets. However, redeemability limits each bank's issue of currency to the quantity its customers choose to hold. A reduction in nominal interest rates on both deposits and earning assets reduces the quantity of currency supplied by banks--that is, the amount the banks would like to supply. The lower nominal interest rates on deposits raises the quantity of currency demanded by their customers. The actual quantity of currency issued by banks matches the demand by their customers. By lowering nominal interest rates, a decrease in the expected inflation rate should bring the quantity supplied and quantity demanded closer to equilibrium.

That is what Friedman's argument about the "optimum quantity of money" amounts to in a free banking system. The quantity supplied and demanded of zero-interest currency may be brought into equilibrium by the correct expected inflation rate--likely a deflation rate. The quantity supplied and demand of deposits, presumably the bulk of the quantity of money in any free banking system, could clear through changes in nominal interest rates paid on the deposits.

If the cost of intermediation through the issue of currency is the same as the cost of intermediation for checkable deposits, then the optimal rate of deflation would be the negative of the competitive interest rate on checkable deposits. If currency is more expensive to print and maintain in circulation, then slightly less deflation would be optimal. As long as the rate of deflation generated by the productivity norm is less than (closer to zero) the rate of deflation that brings the supply and demand for currency into balance, then the productivity norm improves the performance of the zero nominal interest rate currency market relative to price level stability or mild inflation.

If there were a sharp drop in the real interest rate on earning assets, or perhaps a change in risk premia or the term structure of interest rates so that the real cost of intermediation rose, then the expected deflation rate generated by the productivity norm would make it more likely that the issue of currency would become unprofitable. If that were to happen, then banks would stop issuing zero-interest currency and customers would have to make do with deposits.

What if nominal interest were paid on currency? Consider the following scenario--when a depositor withdraws currency from his or her deposit, the principal amount is debited from the account, but the bank continues to credit interest to the account until the currency clears.

Consider an analogy with a paper check. Suppose a depositor writes a check to pay a bill, puts it in the envelope, but leaves it on his desk. The funds in the deposit continue to earn interest. After a few days, the check is mailed. The funds in the deposit continue to earn interest. The check is received and processed. The funds continue to earn interest. Eventually, the check is presented for payment. The bank finally debits the account on which the check was drawn, and no longer pays interest on the funds.

By treating currency in this fashion, continuing to pay interest until withdrawn currency clears, depositors can withdraw currency without opportunity cost. When currency is spent, the expected pattern would be that those receiving the currency, typically retailers, deposit it at their own banks. Currency, like paper checks or electronic payments, would be cleared. The person who withdrew the currency no longer earns interest and the retailer begins earning interest.

It would be possible, of course, for someone to spend currency and the person receiving the currency to hold it, and perhaps spend it again. Currency can circulate. The person who withdrew the currency and introduced it into circulation, earns interest until someone deposits the currency and it clears. Holding currency received in payment does involve an opportunity cost. The solution for an individual bearing an opportunity cost from holding currency is to deposit it.

Given this scenario, what is the advantage of lowering the expected inflation rate and so the nominal interest rates paid on earning assets, deposits, and currency? Paying interest on currency until it clears creates private incentives to deposit currency received in payment rather than hold and then spend the currency. These additional clearings involve real costs. By lowering the nominal interest rates, people will be more inclined to hold and spend whatever currency received in payment, which saves on clearing costs.

In a free banking system, individual banks cannot create an excess supply of currency because of the reflux. Those receiving currency in payment deposit the currency in their own banks. The currency returns to the issuing bank through clearing and results in a reserve drain on the issuing bank. A possible loss in the effectiveness of the reflux in controlling the over issue of currency must be weighed against any savings in clearing costs resulting from the expected deflation implied by a productivity norm.

Deflation and the Optimum Quantity of Money

Years ago, Milton Friedman argued that deflation--a falling price level--is optimal because it is necessary to make make the real rate of return on money equal to its opportunity cost. In Less Than Zero, George Selgin appeals to that argument in support of the productivity norm--a rate of deflation equal to the growth rate of productivity.

The argument can be seen using the Fisher effect of expected inflation on nominal interest rates. In equilibrium, the nominal interest rate is equal to the real interest rate plus the expected inflation rate. Other things being equal, a decrease in the expected inflation rate reduces the nominal interest rate.

The opportunity cost of holding money (at least one of them) is the difference between the interest rate on nonmonetary assets, like bonds, and the interest rate that can be earned on money. Suppose the nominal interest rate on money is fixed at zero and the equilibrium real interest rate on nonmonetary assets is greater than zero. Then a decrease in the nominal interest on nonmonetary assets shrinks the difference with the nominal interest rate on money and reduces the opportunity cost of holding money. Since expected deflation further reduces nominal interest rates below the real interest rate, expected deflation should further close the gap.

Why would anyone hold money with a zero nominal yield when nominal yields on other assets are greater than zero? Steve Horwitz, following Hutt, describes the services received from holding money as a liquidity yield. Each person adjusts the amount of money held so that his or her subjective liquidity yield equals the opportunity cost of holding money.

For example, suppose the equilibrium real interest rate is 3% and the expected inflation rate is 2%. The equilibrium nominal interest rate is 5%. The nominal interest rate on money is assumed to be 0%. The opportunity cost of holding money is 5%. Each person chooses to hold a quantity of money such that his or her subjective liquidity yield on money is 5%.

If the expected inflation rate is negative, say -1%, then the nominal interest rate is 2%. The opportunity cost of holding zero nominal interest money is 2%. Each individual increases the quantity of money held until their subjective liquidity yield is equal to 2% on the margin.

If the nominal interest rate on nonmonetary assets is driven to zero, then each person will demand an amount of money such that the subjective liquidity yield is driven to zero on the margin. The optimal quantity of money will meet the demand to hold zero-yield money at a point where the rate of deflation is equal to the equilibrium real interest rate, and the nominal interest rate on nonmonetary assets is equal to the zero nominal interest rate on money.

Given the example above, a deflation rate of 3% results in a nominal interest rate of 0% on nonmonetary assets. The opportunity cost of holding money is zero. People hold even more money, to a point where their subjective evaluation of liquidity is zero on the margin.

What is wrong with the argument? Under the existing monetary regime, most money earns interest. Using the MZM measure of the quantity of money, 90 percent takes the form of deposits and 10 percent the form of hand-to-hand currency. Deposits can and do pay explicit nominal interest rates.

The yields on deposits are typically less than those on nonmonetary assets, most obviously the yields on the earning assets that banks hold on their balance sheets. While there are many costs of financial intermediation, one cost is due to the creation of liquidity. Banks take earning assets that approximate the actual liquidity characteristics of productivity enhancing investments and transform them into more liquid deposits. This activity is risky, and the stockholders of banks require compensation for providing this service. Depending on the real interest rate generated by productivity enhancing investments and the real cost of providing intermediation services, the real yield on deposits that serve as money can be positive or negative.

For example, suppose the real interest rate on productivity enhancing investments is 3% at the margin. The cost of providing intermediation services, particularly the creation of liquidity, is 1%. The competitive real interest rate on deposits serving as money is 2%.

At first pass, the expected inflation rate has nothing to do with the opportunity cost of holding money. It will equal the cost of providing intermediation services. Each person will hold a quantity of money such that his or her subjective evaluation of the services provided, the liquidity yield, equals the cost of providing intermediation services. In the example, the liquidity yield will be 1%.

If the expected inflation rate is 2%, the nominal interest rate reflecting the real return on investment is 5% and the nominal interest rate on deposits that serve as money is 4%. The opportunity cost of holding money is 1%. Each person holds money such that the subjective liquidity yield is 1%, which is the cost to the banks of providing this liquidity.

If the expected deflation rate is 1%, then the nominal interest rate reflecting the real return on investment is 2%. The nominal yield on deposits serving as money is 1%. The opportunity cost of holding money remains 1%. There is no impact on the real quantity of money held or the liquidity yield on the margin. It remains equal to the real cost of providing intermediation services.

If the expected deflation rate is 3%, then the nominal interest rate reflecting the real return on investment is 0%. The interest rates on deposits is -1%. The opportunity cost of holding money remains 1%. People will hold a quantity of money such that they evaluate the liquidity services at 1%.

But then, there is currency. The government monopolizes the issue of hand-to-hand currency and pays zero nominal interest. The real yield is the negative of the inflation rate. This negative yield generates seignorage revenue from the monetary authority to the government. With a monetary authority organized on banking principles, the central bank can borrow at a negative real interest rate by issuing currency. With a 2% inflation target, the central bank borrows at a negative 2% real interest rate. Deflation creates a positive real yield on currency. The central bank borrows by issuing currency at a positive real interest rate.

The best way to understand the argument regarding the optimal quantity of money and deflation is that it is really about the optimal quantity of currency and deflation. With deflation, the real return on currency can be made equal to the real return on deposits. Rather than obtaining "liquidity" services from holding "money" in place of securities or other nonmonetary assets, people obtain more of the monetary services peculiar to currency rather than the more general "liquidity" services from money inclusive of deposits.

Again, suppose the real interest rate implied by productivity enhancing investments is 3% and the cost of providing liquidity services is 1% resulting in a 2% real interest rate on deposits. If the expected inflation rate is 2%, then the nominal interest rate reflecting productivity is 5%, the interest rate on deposits is 4% and the nominal interest rate on currency is 0%. The real interest rate on currency is -2%. Depositors will restrict currency use and perhaps substitute deposits until the subjective liquidity yield on currency is 4% greater than that on deposits.

If the expected inflation rate is reduced to -1%, then the nominal interest rate on productivity enhancing investments is 2%, the nominal interest rates on deposits is 1%, and the nominal interest rate on currency remains fixed at 0%. The opportunity cost of holding currency relative to deposits is 1%, and so the currency deposit ratio rises until the subjective liquidity yield on currency is 1% greater than the liquidity yield on deposits.

A 2% expected deflation rate would result in a nominal interest reflecting the real productivity of investment of 1%. The nominal interest rate on deposits is 0%, matching the 0% nominal interest rate on currency. The liquidity yield on currency relative to deposits would be zero.

Perhaps more deflation would be desirable. Following Friedman's approach, suppose that expected deflation is 3%. Then the nominal interest rate on productivity enhancing investments is 0%. The cost of intermediation is 1%, and so the nominal interest rate on deposits is -1%. The government is issuing currency with a 0% yield. Deposits shrink, perhaps to zero, or at least until other benefits, perhaps protection from theft, are valued at 1% on the margin. Of course, the provision of liquidity is no longer an issue for the banks, since they could simply hold vault cash, and so storage costs would be relevant. The central bank is providing liquidity services free of change.

Clearly, it is possible that expected deflation could go too far. Suppose the expected deflation rate is 4%. The nominal interest rate on productivity enhancing investments on the margin is negative 1%. The cost of intermediation is 1% but that is subsidized by government. The nominal interest rate on currency is 0% and the nominal interest rates on deposits is negative, but only reflecting storage costs.

There is no private benefit from funding productivity enhancing investments that provide a 3% real yield because, the 4% real return on currency is better. Fewer productivity enhancing investments are made, until the real return is 4% on the margin. That brings the nominal interest rate on those investments to zero, matching the zero nominal yield provided by currency.

Having the rate of deflation and zero nominal interest rate currency driving the allocation of resources between consumption and investment appears highly distortionary on its face. The result is the sort of liquidity trap frequently discussed these days--the zero nominal bound. It is difficult to see how any equilibrium is possible consistent with a stable expected deflation rate higher than the real equilibrium interest rate. Limiting deflation to the increase in productivity and the relationship between the equilibrium real interest rate and expected improvements in productivity should avoid this problem.

While the point of deflation is to increase the currency-deposit ratio so that people can obtain more benefits from using currency rather than deposits that can be used as money (or, more generally, from other uses of resources,) the scenario where the real yield on currency matches that on productivity enhancing investments is especially interesting. Currency is made superior to ordinary bank deposits, though presumably such deposits would be replaced by 100% reserve deposits.

Is that scenario desirable? If the central bank can provide liquidity services at no cost, then having private banks do so is a waste. On the other hand, it is difficult to see why anyone would want to hold any asset that provides the same return as currency but with reduced liquidity--things like certificates of deposits, long term bonds, or equities. And so, the equilibrium would appear to be for the monetary authority, organized as a central bank, to finance the entire capital stock, funded by the issue of hand-to-hand currency.

Considering that scenario for a moment, it becomes clear that the provision of liquidity services by the central bank is not always costless. At some point, having a centralized, politically-controlled bank direct the allocation of capital would be very costly. Competing banks issuing deposits that can be used as money to fund portfolios of assets that approximate the liquidity and risk characteristics of real productivity enhancing investment projects is probably the least bad option. The creation of liquidity through intermediation has real costs.

If there are outstanding short term government bonds, like T-bills, then the cost of having the central bank provide more liquidity services is presumably minimal. It can purchase the T-bills and issue additional currency. As long as the deflation rate implied by the productivity norm leaves the real rate of return on zero-nominal interest rate currency less than or equal to the competitive real interest rate on deposits, the productivity norm allows for a more efficient currency deposit ratio.

What are the public finance implications? Assuming the government is on the efficient side of the laffer curve for the inflation tax, shifts from a higher to a lower expected inflation rate reduces seniorage income. Futher, Selgin (like me,) favors free banking. Does the argument change when the issue of hand-to-hand currency is privatized? Watch for more posts on this topic.

More about the Productivity Norm

In Less Than Zero, George Selgin describes a scenario where an increase in supply in a single market is cleared by a lower price. Because demand is unit elastic, total expenditure remains unchanged in the market. If aggregate total expenditure in the entire economy is fixed, then aggregate expenditures in the rest of the economy is unchanged as well. The change in the one market with the increase in supply doesn't create a net excess demand (or supply) for other goods, and so no need for their prices to rise (or fall.)

But suppose there is a rule imposing a stable price level. What happens? The one price has fallen. The average of prices has fallen (assuming this price was included in whatever measure of the price level is to be stabilized.) To get the price level back up to target, it is necessary to increase the quantity of money, creating an excess supply of money at the current price level. In the long run, the prices of all goods, including resources, are slightly higher. Even the price of the good with the increase in supply is slightly higher than it would have been if there had been no increase in the quantity of money. Of course, it remains lower than it was before the increase in supply that initiated the entire process.

Selgin suggests that stabilizing the price level is needlessly disruptive. The context of this particular argument was "menu costs," the cost of changing particular money prices. Instead of simply lowering the one price with the increased supply, stabilizing the price level requires its price to fall, but a bit less, and all the other prices increase a bit. As Selgin emphasizes in other contexts, however, the menu costs is just one element of the problems created by an excess supply of money.

I am convinced. If there were a situation where a change in the price of a single good left the entire economy in equilibrium, creating monetary disequilibrium to get the price level back to a target would be undesirable. That a regime of price level stability could have this effect counts as a disadvantage.

Understood properly, Selgin's thought experiment suggests that targeting any growth path of nominal expenditure is superior to targeting any growth path of the price level. It does not, however, provide a strong reason to favor the particular growth path of nominal expenditure he favors--a growth rate equal to total factor supply (2%?) rather than productive capacity (3%) or a path generating low inflation (5%.) Given any particular growth path for nominal expenditures, the expectations generated by the regime will impact price setting strategies. There is no need to generate period by period monetary disequilibrium to maintain the trend growth path of prices generated by the regime. Regardless of the trend growth path, changes in productivity will result in changes in the growth path of prices.

With various growth paths of nominal expenditure, Selgin's thought experiment, understood as a ceteris paribus exercise, would imply a slightly lower growth path for prices. That is, if this were an extra improvement in productivity beyond normal, the result is a very slight shift to a lower growth path of prices. Of course, from a different perspective, if productivity increased so little, with just a single good having some improvement in productivity, then the result would be a shift to a higher growth path of prices.


Perhaps there is something to the "menu cost" argument, though I find it hard to believe that the growth process--one properly characterized as creative destruction--can be understood by thinking about an increase in supply in a single market with unit elastic demand.







Selgin uses supply and demand analysis, and with demand unit elastic, (I did my best to draw a rectangular hyperbola,) expenditures on this product and revenues received by sellers are unchanged by the lower price and higher quantity. P1*Q1 = P2*Q2. If aggregate nominal expenditure is unchanged (or left on the same growth path,) then this change leaves total expenditures in the rest of the economy unchanged as well.

However, what does this imply using indifference curve analysis?


This diagram shows income Y and the higher price Pa1 and then the lower price, Pa2. Preferences are such that the decrease in the price of the good results in an increase in consumption from Xa1 to Xa2. The demand for the composite good, Xo, remains unchanged.

Of course, indifference curves apply to an individual, and if this is a representative agent, the result would be unit elastic demand for good a. In reality, some individuals could expand expenditures on good a and reduce expenditures on other goods while other individuals might reduce expenditures on good a and spend more on other goods. Selgin's assumption just requires that on the whole, the mix in total expenditures remain unchanged. (However, adding those complications also suggest that the rest of the economy shouldn't be characterized as a single composite good.)

I suppose it is just my priors, but I think that part of the growth process should instead be characterized by the following indifference curve diagram:






One important aspect of the process of creative destruction is that improved technology allowing greater productivity for one good allows resources to be freed in order to expand the production of other goods. The market process allows improvements in the technology for producing one good to increases the production of whatever particular goods people want to purchase most with the additional real income. An unfortunate side effect of this process is technological unemployment.

How does this relate to the productivity norm? The operations of such a monetary regime would not interfere with the process. Total expenditure on other goods would expand. It does suggest, however, that the impact of a regime of price level stability--higher prices of other goods and services, partly offsetting the lower price of the particular good with improved productivity--would occur with a productivity norm, though to a smaller degree.

A second aspect of the growth process is more difficult to describe using supply and demand diagrams or indifference curves--the introduction of new and better consumer goods and services. Perhaps it is an illusion, but that is the element of "creative destruction," that seems most important to me. How does that relate to the productivity norm?

I think the most plausible scenario is that more is spent on the improved good. There is a higher price and quantity that good. (For a new good, it is clearly higher than the zero price and quantity before it existed) Less remains to be spent on other goods and services. The price of the improved good rises (or there is a new price introduced into the economy.) Other prices fall. The impact on the price level is ambiguous, but let us take that to mean more or less unchanged.

Rather than deflation, this element of the process of creative destruction has little impact on the price level. However, our price level statisticians would note that the apparently stable CPI is allowing the purchase of higher quality goods and services. Using either crude or sophisticated methods to make adjustments, they would show a decrease in the "cost of living." In other words, the statistics would report deflation. Rather than hearing complaints that the CPI understates the inflation that average people can see, the complaints would be of the imaginary deflation that is being reported by the statisticians.

In conclusion, Selgin is correct that a stable growth path of nominal expenditure is better than a stable growth path for the price level. Different growth paths for nominal expenditure imply different trends for various measures of the price level. I don't see the mild deflation favored by Selgin as especially harmful. But then, I am not persuaded that it provides any benefits relative to a growth path of nominal expenditures that results in a stable price level on average.

Deflation and Economic Growth

Some free market economists, and many from the "Austrian" school, favor supply-side deflation. They believe that a growing, dynamic economy should typically be characterized by gently falling prices of final goods and services.

I believe that many "amateur" Austrians favor this view due to a fallacy of composition. Clearly, I wouldn't accuse a great economist like Hayek of such a simple error. Nor do I think those of my fellow free bankers taking this position--Selgin, White, Horwitz, Garrison, to mention a few--are making any kind of simple error. On the other hand, I do sometimes wonder if they have "priors" based on the simple error I am attributing to the "amateurs."

What is the obvious, common sense, (and wrong) perspective?

An improvement in the technology for producing a single good is traditionally illustrated with a supply and demand diagram by a shift of the supply curve to the right.

The immediate result is a surplus of this good at its initial price. But with the improved technology reducing unit costs, firms are more profitable. By lowering prices, they motivate buyers to expand the real volume of purchases--the law of demand. The firms expand production and while they make less money on each item sold and perhaps less revenue in total, the entire process is one of at least temporary profits, expanding production, and a growing real volume of sales.

The end result is a decrease in the equilibrium price for this good and an increase in the equilibrium quantity. The amount of the product flowing through the market--the amount produced, sold, bought, and consumed--is higher.

If this is taken to be the "typical" market, then clearly the result of a dynamic economy with improving technology will be falling prices and rising output.

In other words, it seems natural that a growing, dynamic economy will be characterized by growing real output and real incomes combined with mild deflation

However, a closer look shows that this simple approach is in error.

In the diagram above, the slope of the demand curve includes both a substitution effect and an income effect. The substitution effect for a single market involves a lower relative price providing a signal and incentive for households to better achieve their goals by shifting away from the consumption of other goods towards the consumption of this good.

The income effect occurs because the lower price of this good increases real income. If the same amount is purchased at a lower price, additional funds are available to purchase other goods. Further, more of this good can be purchased without reducing the purchase of other goods.

If this is a normal good, which means that higher real income leads to greater demand, then the income effect due to the lower price reinforces the substitution effect. Both the substitution effect and the income effect of the lower price lead to increased consumption of this good.

On other hand, if this is an inferior good, which means that higher real income leads to less consumption, then the lower price still raises real income, but paradoxically, being able to afford more leads to fewer purchases. Then, the income effect partially offsets the substitution effect.

If a good makes up a small part of household budgets, then the income effect is going to be small. If a household only spends a little on a particular good, a change in the price of that good will only have a small effect on the household's real income. While this small income effect is included in the slope of the demand curve, the increase in real income, should impact other markets as well. The demands for all normal goods should rise and the demands for all inferior goods should fall. Of course, this diagram doesn't show what is happening to other goods, either the substitution or income effects.

If this is taken to be the "typical" market, so that there are supposedly increases in supply in most, if not all, markets, then the substitution and income effects from the other markets are going to significantly impact this "typical" market.

As for the substitution effect, it is evident that all prices cannot fall relative to all prices. Similarly, it is impossible to substitute away from all goods to all goods. The substitution effect, which is central to understanding the consequences of an increase in supply in a single market, cannot be applied to to all markets. Treating a single market as "typical" fails.

And what of income effects?

The notion that the reduced price only has a small effect on real income no longer makes sense when real income and output is expanding because of increased supplies in most or all markets.

If the "typical" good is normal, so that increased real income results in increased demand, then the impact of growing real income due to an increase in supply in the typical market will be an increase in demand in the typical market.

The impact of an increase in supply in the "typical market" is a matching increase in demand. The relative price of the typical good is unchanged, and the quantity rises. The result, then, is growing real output and real income, and a stable price level.

Of course, it is unlikely that all markets will have exactly the same increase in supply. Improvements in technology may be more significant in some markets, and less significant in others. Further, demands rise more for luxuries and less for necessities, and fall for inferior goods. Rapidly rising demand for a luxury with no significant improvement in technology may pull resources away from its substitutes in production. If there were no improvements in technology in those markets, supplies would decreases there.

The growth process is unlikely to be smooth or simple. It is called "creative destruction" for a reason. But to generalize from a single market with an increase in supply to the economy as a whole is an error--the fallacy of composition. What are small, "secondary" effects when technology improves for a particular good become essential parts of the growth process.

Of course, supply and demand curves are conventionally constructed as showing the relationship between quantities supplied and demanded and relative prices. It is trivial, then, that increases in supply cannot cause a lower relative price level. Some prices fall relative to other prices. Those other relative prices must be rising.

Understanding the price level--whether it is stable or there is deflation or inflation--is about money prices. What happens to money prices depends on monetary institutions. The advocates of mild deflation understand this, of course.

But free market "amateurs" beware. A simple minded application of supply and demand analysis won't do. It is essential to develop a sound understanding of monetary economics. How does the growth process impact the demand for money? And, how do various monetary institutions allow the real quantity of money adjust to that demand?

Selgin on the Productivity Norm

George Selgin's Less Than Zero is now available online. His discussion of monetary disequilibrium is very good. As usual, he provides great scholarship on the history of thought and interesting economic history as well.

I still favor targeting the growth path of nominal expenditure at 3 percent, which would result in a stable price level on average. Selgin's arguments against trying to reverse changes in the price level due to unexpected changes in productivity are persuasive. I am less convinced by the arguments for a trend rate of deflation. The trend growth rate in productivity can be anticipated, and especially, a targeted growth rate for nominal incomes can be anticipated.

Unemployment Rates: Inclusive and Standard

In a post on Liberty and Power, Robert Higgs has an excellent discussion of an inclusive measure of unemployment, u-6, and the standard measure u-3. The standard measure had risen to 10.2 percent by October. The more inclusive measure was 17.5 percent. What is included in the u-6 measure? He quotes from the BLS, describing various items added to the standard measure to obtain the inclusive measure:

“Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.”

Of course, the standard measure takes those actively looking for work and divides by the labor force, which includes both those who are working and those who are actively looking for work.

Higgs introduced his post:

As the recession has deepened and the rate of unemployment has risen, a number of commentators have sought, for various reasons, to portray the situation as far graver than the “official” rate of unemployment indicates. Some of these commentators charge that the government is deliberately misrepresenting the amount of unemployment and that the “real” rate of unemployment is much greater than the official rate that the government announces and the news media report each month

I had the same impression listening to these alarmist reports, but I think that the key question is how much the more inclusive measure has risen relative to the standard measure during the recession. And so, I looked up the figures.

The graph below shows the standard rate and the inclusive rate since 1999.

The two series generally move together. For example, the standard rate went from 4.9 percent in December 2007 when the recession began to its current 10.2 percent rate. The more inclusive rate was 8.7 percent when the recession began and is now 17.5 percent. This increase in both implies a substantial increase in the gap between them.

The difference increased from 3.8 percent to 7.3 percent. With a labor force of 234 million, that is a lot of people--about 17 million. The "extra" people in the uncounted group today relative to the more normal 3.8% would be about eight million.

What proportion of the people in the more inclusive group are uncounted by the standard measure?

The Great Recession doesn't appear to have resulted in a large increase in "hidden" unemployment. I think the alarmist media reports are making the error of comparing the 4.9 percent standard unemployment rate at the beginning of the recession to the 17.5 percent inclusive measure of today.

On the other hand, millions of the people who are now discouraged workers, working part time but who want full time work and marginal workers, might be working if the economy were not in recession. Further, even when the economy is not in recession there are millions of people in those groups, suggesting that labor markets have problems. Is there an opportunity for free market reforms to generate a significant increase in potential income? The conventional wisdom (which I share) is that taxes and regulations disturb European labor markets, substantially reducing the productive capacity of Europe. These figures suggest that it is not so rosy in the U.S. either.

Interest Rates and "Tight" Money

An excess demand for money exists when the quantity of money is less than the demand to hold money. That is how I would define "tight money."

Such a shortage of money results in people reducing expenditures out of income in order to increase money balances. One of the many things upon which people might reduce expenditures is bonds. Further, an alternative way of building up money balances is to sell nonmonetary assets. One such nonmonetary asset is bonds. People short of money can sell bonds.

If this occurs, and bond prices fall, then the yields on bonds increase. In other words, an excess demand for money can plausibly lead to an increase in "the" nominal interest rate.

Some monetary assets pay interest as well. Typically, currency pays no interest, but checkable deposits can pay interest. If the nominal interest rates on bonds rise, and the nominal interest rates on monetary assets are unchanged, then the opportunity cost of holding money is higher. Holding money is less attractive than holding other assets.

Suppose money demand takes the following form:

Md = P md(Rb-Rd, y, x)

Where:

P is the price level and md is the demand for real money balances. The demand for money is a demand for purchasing power, and so nominal money demand is proportional to the price level.

Rb is the interest rate on bonds and Rd is the interest rate on monetary assets, so Rb-Rd is the opportunity cost of holding money (or at least one of the opportunity costs.) The demand for real money balances is negatively related to the opportunity cost of holding money.

y is real income. The demand for real money balances is positively related to real income. In other words, money is a normal good.

And finally, x represents other things that could impact money demand.

If there is a shortage of money, so Ms is less than Md, then, other things being equal, and increase in Rb, the interest rate on nonmonetary assets, can result in Md falling to match the existing quantity of money. This is often called the "liquidity effect" and plays an important role in Keynesian monetary theory.

The above diagram shows the Keynesian money market. "The" nominal interest rate on nonmonetary assets changes so that quantity of money demanded adjusts to the existing quantity of money. This is given the price level, real income, and the interest rate paid on money. Changes in any of those things shifts this money demand curve to the right or left and so causes changes in the nominal interest rate.

Does this mean that nominal interest rates can adjust to clear up monetary disequilibrium? No. Interest rates have an important role in coordinating saving and investment.

Saving is that part of income not spent on consumer goods and services. Saving results in an increase in net worth and an ability to increase consumption in the future. A higher real interest rate provides a signal and creates an incentive to reduce current consumption, increase saving, add more to net worth, and expand future consumption expenditure.

Investment is expenditure on capital goods--machines, buildings and equipment. While producing additional capital goods now reduces resources available to produce consumer goods now, the additional capital goods raise labor productivity and increases the ability to produce consumer goods in the future. A higher real interest provides a signal and creates an incentive to reduce investment expenditure, produce fewer new capital goods, and add less to the ability to produce future consumer goods. However, by producing fewer capital goods now, resources are freed to produce consumer goods now.

If the real interest rate is at the right level--the natural interest rate--then saving and investment are coordinated. Firms produce the amount of consumer goods now that households want to purchase now. Firms purchase and produce capital goods, increasing the capital stock to match the increase in the households net worth. And the additional capital goods increase the firms' ability to produce consumer goods in the future, matching the increase in the households' ability to purchase consumer goods in the future.

The diagram above illustrates the natural interest rate, the real interest rate that coordinates saving and investment.

Because changes in current income can also impact saving, the concept of the natural interest rate can be ambiguous. Keynes emphasized this point. In his view, income and saving adjust until saving equals investment at a given interest rate. Further, the conventions of national income accounting include unplanned inventory investment as one sort of investment, which makes saving and investment always equal by definition.

However, the traditional approach has been to identify the natural interest rate as the level of the interest rate that coordinates planned investment and saving with income at a level consistent with productive capacity.

Since investment and consumption both represent demands for current output, and are both negatively related to interest rates, ceteris paribus, there is a negative relationship between real expenditure and real interest rates. The level of "the" real interest rate that generates a level of real expenditure that matches potential income--the productive capacity of the economy--is the natural interest rate.

The diagram above shows an IS curve, which is traditionally the combinations of real income and interest rates consistent with saving and investment being equal. However, it is better interpreted as the negative relationship between real interest rates and real expenditure on final goods and services. The "y" along the horizontal axis is real expenditure on final goods and services rather than production. The vertical line represents the productive capacity of the economy. Then rn, the natural interest rate, is where total real expenditure is equal to the productive capacity of the economy.

If the level of the nominal interest rate that results in a demand for money that matches the quantity of money results in a real interest rate greater than the natural interest rate, then saving is greater than investment and real expenditure is less than the productive capacity of the economy.

The diagram above shows the interest rate where the quantity of money demanded has adjusted to the existing quantity of money as R*. The expected inflation rate is positive, and when subtracted from R* generates a real interest rate r*. The real interest rate is above the natural interest rate. Real expenditures given r* is less than the productive capacity of the economy.

Has the shortage of money been corrected by the increase in the nominal interest rate? I think not. The interest rate needs to coordinate saving and investment--the production of consumer goods and spending on consumer goods through time. The quantity of money demanded at a nominal interest rate equal to the natural interest rate plus the expected inflation rate is greater than the quantity of money. The impact of a shortage of money on the nominal interest rate is just part of a disequilibrium process.

An excess demand for money exists when the quantity of money is less that what the demand to hold money would be if nominal interest rates are where they should be.

And where should the nominal interest rate be? It should be equal to the sum the expected inflation rate and the natural interest rate--the level of the real interest rate that coordinates saving with investment and maintains a level of real expenditure equal to the productive capacity of the economy.

This discussion of the relationship between monetary disequilibrium and interest rates is only a first pass. Most obviously, the relationship between real and nominal interest rates depends on expected inflation. Expectations about the future quantity of money and the demand to hold it are going to feed back to current money demand.

Worse, if changes in real expenditure impact expected future real income and output, then saving, investment, and the natural interest rate can change. The notion that "tight" money must imply that interest rates are higher than usual is fraught with difficulty.

Further, the liquidity effect isn't the sole relationship between money and interest rates. Banks create a substantial part of the quantity of money, so an imbalance between the demand for money and the quantity of money has implications for both the nominal and the real quantity of credit. With a monetary authority organized as a central bank, many of its operations are also best understood as impacting the nominal and real supply of credit.

And there are other avenues by which a shortage of money can impact real expenditures than through a divergence between the market and natural interest rate. Those short on money might directly reduce expenditures on currently produced output. Reduced real expenditures and a reduced volume of sales will likely result in less production of goods and services and so, less real income. And that too will impact money demand.

More on the complicated relationship between "tight money" and interest rates later. However, a first passt at real real output and real income comes first.

Residential Investment

The recent real GDP figures showed that residential housing construction rose at a 23 percent annual rate in the third quarter. Presumably this was related to the tax credit for first time home buyers, the purchases of huge amounts of mortgage backed securities by the Fed, and lower housing prices.

Of course, a 23 percent annual growth rate is a bit over 5 percent during the three month period, which doesn't look quite so large.

However, is is remarkable how residential construction remains compared to the 2005 peak. I put together the following graph at the St. Louis Fed site.

The blue line represent real investment and the red nominal investment. Real residential investment remains 53 percent below the peak and nominal residential investment is 55 percent below its peak.

World Economy Graphic (from Mankiw)

The Layman's Version of Supply and Demand

The layman's version of supply and demand answers the question, "what can they possibly be thinking?"

It is just commons sense. Price is how much the buyer pays the seller. A higher price means that the buyer pays more to the seller, and so the buyer is worse off and the seller is better off. A lower price, on the other hand, means that the buyer pays less to the seller, and so the buyer is better off and the seller is worse off.

The most important question is determining the fair or reasonable price. That is the price that takes the unit cost of production and adds a fair or reasonable profit.

There are two important questions regarding quantity. One quantity is the amount people need. The other quantity is the productive capacity of the firms. Hopefully, firms will have a productive capacity that matches the needs of the public.

First, the layman's demand curve. It's just common sense.

The key characteristic of this demand curve is Qn, the amount of the good that is needed by households. Of course, everyone knows that if the price gets too high, no one can afford it and none can be sold. That is Pm, which is what market will bear. It is just common sense.

Now for the layman's supply curve.

The key characteristic of the layman's supply curve is Qp, the productive capacity of the firms. However, everyone knows that if firms cannot cover their production costs, they will all fail and produce nothing. So the supply curve shows Pc, which is the unit cost of production. It is simple, common sense.

Like the economists' version of supply and demand, the two curves are put together.

This particular diagram shows equilibrium, the fortuitous situation where firms are able to produce what households need and charge a fair price. The vertical segments of the supply and demand curves overlap. The price is between the unit cost of production and what the market will bear. The price happens to be at the fair or reasonable level, where the markup or unit profit is at the fair or reasonable level.

Market ideologues believe that a so-called invisible hand will result in this happy scenario. How likely is that given the large bargaining range between what the market will bear and the unit cost of production? What is the chance that big business and thousands of households will have equal bargaining power?

This diagram shows a situation where firms produce the amount people need but also the vast bargaining range. The diagram below shows the typical situation, especially likely when pro-business (Republican) politicians are in power, and firms charge Pg, the greedy price.

This is why it is essential to have a strong government willing to protect the little guy (Democrats).

P.S. The economists version of supply and demand has quite different implications. Remember this?

P.P.S. Look for future posts about the layman's version of labor markets, price ceilings, and price floors. It is just common sense.

Free Banking, Micro and Macro

Free banking has both microeconomic and macroeconomic aspects.

"Micro" free banking is only loosely related to whatever fundamental nominal anchor exists for the monetary system and monetary policy. Those are the questions that are central to "macro" free banking.

Reforms related to "micro" free banking include the private issue of hand-to-hand currency and token coins, ending reserve requirements, ending restrictions on branching, ending capital requirements, ending government deposit insurance, privatized interbank clearing operations and perhaps more. "Micro" free banking is about deregulation of the banking system. The key idea is that banks should be subject to the general rules regarding freedom of contract. The only "regulation" appropriate to banking would be closely tied to the general prohibition of fraud.

As a rough rule of thumb, each possible reform stands alone. Banks issuing hand-to-hand currency could be subject to reserve or capital requirements. Reserve requirements could go, while capital requirements and the existing ban on banknotes remain. Deposit insurance could be expanded to apply to bank-issued currency or discontinued from some or all deposits.

Of course, there are interactions among regulations. For example, ending capital requirements while keeping government deposit insurance would be very dangerous--especially to the deposit insurer, and so, the taxpayers.

These "micro" reforms are consistent with bank-issued money, both currency and deposits, being denominated in the official unit of account. In the U.S., that is "the dollar." Further, they are consistent with bank-issued money, again, both currency and deposits, being redeemable in dollar-denominated base money. The monetary authority, perhaps organized as a central bank like the Federal Reserve, could still implement a monetary policy. In particular, the Fed could target the federal funds rate and aim to achieve a 2% inflation rate for the CPI starting from where ever the CPI happens to be.

There are two basic categories of "macro" free banking. The Hayek version was outlined in his "Denationalization of Money." Banks issue monetary instruments, both currency and deposits, denominated in unique units. In other words, various banks simultaneously introduce new units of account and hand-to-hand currency and deposits denominated in those units. Hayek assumed, reasonably enough, that each bank would manipulate its issue of monetary instruments to maintain their purchasing power. Households and firms would then choose between monies and units of account based upon whatever criterion they want, though Hayek assumed that monies of stable purchasing power would dominate. While there is a sort of monetary policy under this scheme, these are really monetary policies developed by a variety of different banks. There is no "central bank" providing overall guidance, and so this is a type of "macro" free banking.

The alternative version of free banking, what I call the "Mises" version, is based upon a common unit of account. Rather than the dollar being defined as a unit of money whose value can be manipulated by the monetary authority, it is defined in some other way. The obvious approach, and the one assumed by Mises, is that the dollar is defined as a fixed weight of some commodity, like gold. The nominal anchor of the monetary system, then, would be the fixed dollar price of gold. The assumption is that the various banks denominate their deposits and currencies in dollars and tie them to gold, or whatever commodity is used, by redemption. While there is a sort of "monetary policy" in the system, it is really just a market process that results from the interactions of the banks as well as the supply and demand for gold. Because there is no central bank providing guidance to the system, the result is "macro" free banking.

George Selgin's Theory of Free Banking described a version of "macro" free banking that is a bit unusual. He described the operation of a free banking system where each bank issues dollar-denominated monetary instruments and all of them are redeemable with government-issued base money. However, the quantity of base money is fixed once and for all. This is "macro" free banking because there is no central bank providing overall guidance to the monetary order. It fits into the "Mises" version because the assumption is that there is a common unit of account and that banks tie their monetary instruments to that unit of account by redeemability.

Greenfield and Yeager's "Black-Fama-Hall" payments system is a version of "macro" free banking that is also of the "Mises" variety. There is a common unit of account, like the dollar, but rather than being defined in terms of a single good, like gold, it is defined in terms of a broad bundle of goods. The sum of the dollar prices of the items in the bundle must equal the defined dollar value of the whole bundle, but the dollar price of each good in the bundle is free to vary with supply and demand. Rather than being tied to the bundle-defined unit of account by redemption in all of the various items in the bundle, the dollar-denominated currency and deposits issued by banks are redeemable in terms of some redemption medium, perhaps gold, equal in current market value to the total value of the bundle. The price of the redemption medium varies with supply and demand. This fits into the "Mises" version of macro free banking because there is a common unit of account and the banks tie their money to it by a type of redeemability. There is no central bank providing overall guidance. Any monetary policy is generated by the interactions of the banks operating under the system.

Because of problems with the operation of the BFH system, which I call "the paradox of indirect convertibility," some of those who found the system appealing, chiefly Kevin Dowd (and me,) began to favor a modified system that I call index futures convertibility. Again, the system assumes a common unit of account, like the dollar, with banks issuing dollar-denominated currency and deposits. There is a system of redeemability with index futures contracts that ties each bank's currency and deposits to the common unit of account. This approach to free banking was developed on the assumption that index futures contacts would be on a price index defined on some bundle of goods. However, the system can be modified to stabilize just about anything, including a growth path for a measure of nominal expenditure. There is a sort of monetary policy, though it really just the outcome of the interaction of the banks and speculators in futures contracts. Because there is no central bank providing overall guidance, it is a version "macro" free banking and of the Mises type.

I think it is important to distinguish between "micro" and "macro" free banking, and among the "macro" free banking systems, between the Hayek and Mises types. Of course, there is a broad variety of "macro" free banking systems of the "Mises" type too. Oddly enough, the Rothbardians associated with the Mises Insitute favor a Mises version of macro "free banking." a gold standard, while simultaneously favoring a draconian "micro" regulation of the banking system, a 100 percent reserve requirement.

What do I think? As for "micro" reforms, I think reserve requirements are at best pointless and often harmful and should be dispensed with immediately. I also favor the immediate repeal of the ban on private banknotes. I favor allowing banks to issue dollar-denominated currency and token coins on the same terms as transactions deposits. We will then see if banks can induce their customers to use them, though I expect there would be little problem. If private banknotes and token coins are successful, I would favor withdrawing all government currency, like Federal Reserve notes and coins from the U.S. Mint, from circulation.

I don't favor abolishing deposit insurance overnight, and capital regulations are the least bad means of controlling the moral hazard created by deposit insurance. Careful and gradual reform aimed at weaning the banking system from government deposit insurance, while freeing banks from capital requirements is an appropriate long term goal.

I think the Hayek type of free banking should be permitted immediately. If some bank wants to offer deposits or currency in its own unique units, then they should be permitted to do so. Similarly, banks should be able to issue deposits or currency denominated in gold or silver. We will then see if they can induce their customers to switch to a new unit of account. I doubt it that much will come of it and that banks will continue to issue dollar-denominated monetary instruments redeemable into base money.

As for "Mises" version of free banking, I am skeptical of a gold or silver standard or a frozen quantity of base money. I don't believe all the bugs have been worked out of index futures redeemability, but I think that is the right approach for "macro" free banking. In the meantime, I favor having the Federal Reserve target a slow and steady growth path for nominal expenditures. Imposing index futures convertibility on the Fed is a possible first step towards "macro" free banking.

"Classical" Gold Standard and a Gold Exchange Standard

Leo commented on my earlier post regarding monetary central planning:

How do you differentiate between a "classical" gold standard and a gold-exchange standard? I believe Austrians prefer the former in which money is not "fixed" to a particular price of gold but defined as a specific weight of gold, and the price floats.

At the level of constitutional monetary reform, introducing either a "classical" gold standard or a gold exchange standard involves choosing a price of gold. To say that one dollar is a certain weight of gold, say, a dollar is 1/200 of an ounce of gold is the same thing as saying that the official, defined price of gold is $200 per ounce.

Changes in the weight of gold that defines the dollar are equivalent to changes in the dollar price of gold. Such changes (devaluations or revaluations) could be constitutionally prohibited, or could require special procedures--supermajorities of some sort.

Changing the unit of account to gold ounces is also possible, but at the level of constitutional reform, the shift still involves choosing a dollar price of gold in order to shift from the existing dollar-denominated world to the new system. If the "gold ounce" unit of account were introduced, changes in the price or weight of gold would similarly require the introduction of a new unit of account, though a special "ounce" applying to gold only would be possible.

People should be free to introduce alternative units of account, like gold ounces, and quote prices, keep accounts, and make contracts in terms of those alternatives if they want. Because of the advantages of using the same unit of account everyone else does, this freedom is unlikely to have much impact. Only if a Zimbabwe-like hyperinflationary disaster occurs, could a gold standard evolve in the midst of the wreckage. This would be an example of getting rid of all existing money and waiting to see what evolves.

The live issue is constitutional monetary reform--a shift to a new definition of he dollar. Commodity standards, like a gold standard, are possible candidates. But introducing a commodity standard involves choosing an initial dollar price of the commodity.

Most Austrians oppose having a monetary authority or central bank issue monetary instruments and instead favor leaving that to private banks. Still, if a monetary authority issues dollar-denominated currency or deposits, making those monetary instruments redeemable in the amount of gold that defines the dollar is a way of enforcing the requirement that the market price of those instruments remain at par. That is equivalent to having the paper money price of gold remain equal to its defined price.

That the gold price of paper currency denominated as one dollar cannot be 50 cents is the same thing as saying that the paper currency price of gold cannot be 2 paper dollars per gold dollar.

With free banking, it is the same. If each bank is obligated to redeem its dollar-denominated currency and deposits with gold, that is a way of enforcing the obligation that the market price of its monetary liabilities remain at par. This is equivalent to the price of gold in terms of those notes or deposits remaining at its official, defined price.

My perspective is influenced by awareness of the various interventions that gold bugs/bullionists/ merchantilists used in the early modern period to encourage gold coin and gold reserves. Reserve requirements are the most blatant, but the ban on the option clause and restrictions on small denomination banknotes had the same goal. The "classical" gold standard was rife with regulations that prevented movement towards what would amount to a privatized gold exchange standard.

Regardless, the relative price of gold depends on the supply and demand for gold, including the demand, if any, for monetary purposes. With a gold standard, the price of gold is fixed by definition, and so the price level must adjust to clear the market for gold. The banking system, issuing gold-denominated monetary liabilities, must restrict both the total quantity issued and the amount of each type to the demand to hold them in order to keep the prices of those monetary liabilities at par. Changes in the amount of gold demanded for monetary purposes has the same macroeconomic effect as changes in the demand for gold for use as jewelry. If governments hold stocks of gold, then changes in the government demand for gold can have macroeconomic impacts.

For example, suppose in the aftermath of World War I, a large proportion of the world gold stock was held by the Federal Reserve. How the Federal Reserve chose to manage that stock would have implications for the equilibrium relative price of gold and so world macroeconomic conditions. It is unclear to me how much difference it makes whether such manipulations occurred under a classical gold standard or a gold exchange standard.

What Should the Fed Do? (Newspaper Column Version)

Finally, production is rising. Real Gross Domestic Product increased at a 3.5 percent annual rate in the third quarter. The real volume of consumer goods and services expanded 3.4 percent. Purchases of durable goods, including automobiles, expanded 22 percent. Nondurable goods, like food and clothing, expanded 2 percent, while services, like health care, expanded 1.2 percent.

The real volume of capital goods sold to business—machines, buildings, and equipment—decreased 2.5 percent. Most of that decrease was in industrial and commercial construction—9 percent. Equipment and software slightly increased, about one percent. Production of new homes increased 23 percent. The real volume of output absorbed by the federal government rose nearly 8 percent, but state and local government utilized 1.1 percent less. Some of the consumer and capital goods sold were produced in other countries—the real volume of imports expanded 17 percent. However, the real volume of exports, sales to foreigners, expanded nearly 15 percent.

While production is growing, it had fallen nearly 4 percent from its previous peak in the second quarter of 2008. Despite the increase last quarter, production remains 3 percent below that past peak. If production continues to expand at a 3.5 percent annual rate, it will take nearly a year to regain lost ground. Worse, the production of goods and services should have been rising all along, approximately 3 percent per year. Actual output is nearly 7 percent below productive capacity, according to C.B.O. estimates. Recovery at the current pace is so slow that closing the gap between actual output and the productive capacity of the economy will take years.

What about inflation? The annual rate of inflation in the third quarter, as measured by the GDP deflator, was slightly less than one percent. This modest increase in the price level masked a significant change in relative prices. Inflation was concentrated in nondurable consumer goods— 9.6 percent. Inflation in consumer services was only 1.6 percent. The prices of durable consumer goods fell 3 percent. Similarly, the prices of capital goods had 6 percent deflation and prices of new homes fell nearly 2 percent.

A rapid increase in prices combined with a modest increase in real volume suggests that the capacity to produce nondurable consumer good is limited. This points to malinvestment. Austrian economists Ludwig Von Mises and F.A. Hayek emphasized that productive capacity developed during a boom can be inconsistent with the preferences of consumers. C.B.O. estimates of productive capacity show slower growth over the past few years, falling from the usual 3 percent to 2.5 percent in 2005 and 2 percent last year. Perhaps this fails to fully account for the need to reallocate resources away from residential construction. While residential construction expanded last quarter, it remains nearly 53 percent below the peak reached in 2005.

Shifting resources to meet consumer demand requires producing the appropriate capital goods and moving workers between jobs. The structural unemployment associated with moving workers from where they are needed less to where they are needed more has always been both painful and persistent. A period of unusually slow growth in production and only gradual reductions in unemployment may be unavoidable.

However, low expenditures have exacerbated these problems. Total final sales of domestic product is nearly one percent below its peak in third quarter of 2008. Worse, the U.S. economy had adjusted to a 5 percent growth path of spending. Even if the past growth path of expenditures were adjusted to a 3 percent, noninflationary growth path, total spending is approximately 7 percent too low.

The Federal Reserve should commit to a target for $16.1 trillion for total final sales of domestic product for the fourth quarter 2010. That would require an 11 percent increase in nominal expenditures starting from third quarter 2009. Once total spending has returned to that growth path, future increases should be limited to a 3 percent growth rate—the rate consistent with long run price stability.

If the Fed increased the quantity of money enough for total expenditures to return to its previous growth path, what would happen to production and unemployment? It is likely that production would grow rapidly in response to increased expenditures and unemployment would fall dramatically. Unfortunately, a full recovery to the past trend for real output would be more gradual. Similarly, unemployment is likely to remain high, with gradual reductions in underlying structural unemployment allowing a return to an unemployment rate between 4 and 5 percent.

What would happen to inflation? The short run effect would be an increase in inflation. Productive capacity is limited in the industries producing what people want to buy now—apparently, nondurable consumer goods. Rising prices and profits in those industries will create incentives to expand productive capacity and employment. As resources are shifted and productive capacity adjusts to the new pattern of demand, not only will production expand and unemployment fall, prices of those goods will fall as well, reversing the temporary inflation.

Unfortunately, the Fed’s current policy is to commit to an extended period of low interest rates and a vague promise to so-called ”price stability,” a 2 percent annual increase in the CPI starting from wherever it happens to be. The Fed needs to commit to getting nominal expenditures back to a sensible growth path over the next year. The Fed should not try to keep adverse changes in productive capacity from causing temporary inflation. Nor should it prevent a deflation of prices as productive capacity recovers.

Finally, promising to keep interest rates at very low levels is a mistake. If the Fed commits to a rapid recovery of nominal expenditure, growing credit demand will rapidly increase market clearing interest rates. Promising to keep interest rates lower than dictated by market conditions is likely to lead to excessive inflation and even future malinvestment. While the Fed’s traditional policy appeared effective for over twenty years, the “Great Recession” proves that a new approach is needed.

Am I a Monetary Central Planner?

In a comment on the Austrian Economists blog, Richard Ebeling takes me to task, writing:
(Try this link and scroll down if the other doesn't work.)

But I find myself in disagreement with Bill Woolsey. Why should the government "target" anything, including nominal income?

In a free market, including a free monetary system, nominal income would be whatever the cumulative interactions of the market participants generated in terms of their demand to hold various forms of money and the supply of commodity money and money substitutes.

End of story. I'm sick and tired of social engineering of any type or form. Who are these nominal income targeting "experts"? How do they know how much nominal income should be in the economy and what its "growth path" should be?

This is just another form of monetary central planning. Another form of Friedman's "rule" following.

I don't think nominal expenditure targeting is monetary central planning. What should the target for nominal expenditure be at any time? It should be 3% higher than the previous period. Where does 3% come from? The long run trend growth rate in real output.

But where does the growth path start? I start it from 2nd quarter 2008, before the downturn in nominal expenditure started. However, it doesn't really matter. If nominal expenditure targeting had been implemented in 1985 or 1929, a much different initial level of nominal expenditure would have been appropriate. I don't think starting from the current level of nominal expenditure is appropriate, because it has recently decreased and I don't believe that prices and nominal incomes have adjusted.

Ebeling holds out an alternative of commodity money and free banking. I favor free banking as well, so the difference is the commodity money. Which commodity? What should happen to the price of the commodity? Stay fixed forever? Then at what price should it start? The answers to those questions is what determines the nominal anchor of the free banking system he proposes. Does the answer to those questions amount to monetary central planning?

Abolishing all money, returning to barter, and seeing what evolves is not a realistic approach.

Returning to a gold standard at some particular price of gold would be a significant government intervention.

Still, it isn't monetary central planning. Nominal values will adjust to this anchor.

Under Eberling's approach, the government is going to be fixing the price of one good. And then all nominal prices in the economy will adjust in order to clear the market for that good. Nominal income will depend on those nominal prices and a volume of real production determined by market forces--roughly the productive capacity of the economy. In my view, the market process by which prices and nominal incomes adjust throughout the economy to clear the market for the one good serving as nominal anchor is likely to be very disruptive to the process of production.

With nominal expenditure targeting, nominal prices will adjust to clear various markets. Real income will depend on the same market forces that determine productive capacity. The price level will change with fluctuations in productive capacity, but it should remain stable on average. Generally, nominal prices will rise for goods with higher relative prices and fall for goods with lower relative prices. Nominal interest rates will change with real interest rates. If productivity is temporarily impaired, nominal prices of goods and services rise to reflect the greater scarcity of products. If productivity is enhanced, the greater abundance of good will be signaled by lower nominal prices.

What is the better macroeconomic environment for microeconomic coordination? I think fixing the nominal price of gold is not as effective as slow, steady growth in nominal expenditure. And so, the nominal anchor for free banking should, if it is possible, be a growth path for nominal expenditure that reflects slow steady growth.

Who wants 10% inflation and a 0% nominal interest rate?

Kevin Grier claims that both Krugman and Sumner are wrong. Pete Boetke cites him with approval.

Grier asks,

Can the Fed set the real interest rate at whatever value it wants? I don't
think so.

Do you think they could simultaneously credibly commit to say 10% inflation
and successfully hold the nominal interest rate at zero? Me neither.

What about the simultaneous achievement of 5% expected inflation and a zero
nominal interest rate? Doubtful at best.

What does he mean?

I think he means that if the Fed successfully targets inflation at 10% or 5%, then nominal interest rates will be higher than zero.


I know that Sumner would consider getting nominal interest rates above zero a good thing.

(And, as an aside, Sumner favors returning nominal income to the growth path of the great moderation. My estimate of a target consistent with that growth path for the 4th quarter of 2010 would be about $17 trillion. While that may result in higher expected inflation, the point is to raise real output and employment.)

Getting nominal interest rates above zero is a good thing because of the liquidity trap. If higher expected inflation raises nominal interest rates above zero, then market forces can determine levels of real interest rates that clear markets.

If market forces create an excess supply of credit (or saving greater than investment) at a real rate equal to a zero nominal rate minus the expected inflation rate (usually deflation in this scenario), then the zero nominal bound creates a problem.

That problem is corrected if the expected inflation rate is high enough to get the nominal interest rate high enough that the market clearing real interest rate can be reached.

If prices and wages are perfectly flexible, then real expenditure is always equal to productive capacity, then reductions in real output always reflect decreases in productive capacity.

Either the lower price and wage levels impact the natural interest rate (saving and investment, or the supply and demand for credit as you prefer) or else the price level overshoots (or perhaps one should say, undershoots) creating expected inflation and the market clearing real interest rate.

If prices and wages are not perfectly flexible, then real expenditures can be less than productive capacity and there is demand-constrained production. Production is below capacity until the price level is low enough to raise real expenditures back up to productive capacity.

Raising nominal expenditures fixes that problem. Lower market rates should raise nominal expenditures. But at the zero nominal bound, nominal interest rates can't fall. If it is possible to convince people that prices will rise more rapidly eventually, then even at the zero nominal rate, the implication is a lower real rate. There is presumably some expected inflation rate that is consistent with a market clearing real rate and a zero nominal rate, but if the expected inflation rate is higher than that, the nominal rates rise above zero and real rates still clear markets.

Does Grier believe that prices are always at the proper level so that real expenditures equals productive capacity so that current low levels of real output entirely reflect lower productive capacity? He doesn't say.

Does he believe that the current real interest rates clear markets? That is, the price level now must be at a level so that its expected future rate of of change when subtracted from current nominal rates clear markets? He doesn't say.

As far as I can see, he only seems to be arguing that the Fed cannot keep nominal rates at zero and inflation at 10% or 5%.

So? Is there anyone who considers zero nominal interest rates an end in and of itself?

While I see no value of targeting some high level of inflation, getting nominal interest rates up by shifting expectations is what I think needs to happen.

I favor a target for nominal expenditure--final sales of domestic product--at $16 trillion for the 4th quarter of 2010. This is based upon a modified growth path for nominal expenditure, moving from the planned 2% inflation of the Great Moderation to price level stability. A commitment by the Federal Reserve to expand the quantity of money enough to hit that target will almost certainly cause both nominal and real interest rates to increase at the same time real output and employment grow.