Wednesday, September 19, 2012

Mises on Gold and Fractional Reserves

Brad DeLong wrote a long speculative post where he uses "Ludwig Von Mises" as a foil, imagining what Mises must be saying, generally things inconsistent with what Mises wrote.   He was prompted by Krugman's post which wondered what Ron Paul or "Austrians" think about money market mutual funds.

Mises was not opposed to fractional reserve banking.  He did think it caused economic distortions at least sometimes.   Starting from monetary equilibrium, an increase in the quantity of money created by fractional reserve banks would push the market interest rate below the natural interest rate.  (While I don't worry about what Mises really thought, I think this thought experiment assumes a given demand to hold money.)

Mises did think that the creation of money through mining gold leads to economic distortion.   Still, he didn't oppose gold mining and the "free" minting of coins.

The economic distortions created by gold mining and fractional reserve banking were not worrisome to Mises.

The problem that concerned Mises was an effort to hold the market rate below the natural interest rate by money creation.   In his view, this could not happen to any significant degree in a gold standard with banks issuing redeemable notes and deposits.   He didn't say that gold mining and fractional reserve banking would cause no problems.   He just thought the problems would be minimal.

The problem becomes serious, in his view, when government interferes with the contraints.   Central banking, in his view, was about avoiding the constraints of the gold standard so that the market rate could be kept below the natural rate for an extended period of time--well, the implicit goal was permanently, but Mises thought that was impossible.

For Mises, Depressions are always about the market interest rate rising back up to the natural interest rate.   The unemployment associated with them was fundamentally about reallocation from the production of capital goods to consumer goods.   However, much of that shift would really be shifts in the production of different types of capital goods--from capital goods that help produce consumer goods in the distant future to capital goods that help produce consumer goods in the nearer future.

Using monetary policy to "fix" depression, in Mises' view, is pushing the market interest rate back down below the natural interest rate.   In his view, the market rate should just be left at the natural rate, and the reallocation should be allowed to occur.   The production of some capital goods should be allowed to expand while others contract.   Workers who lose jobs in sectors than need to contract should get new jobs in sectors that need to expand.    

As I have explained before, it is Mises' student Rothbard who thought that fractional reserve banking is fraud and should be illegal.  He also argued that gold mining would not cause economic distortions.

Rothbard is best understood as always arguing that the market is all good and government is all bad.  While Mises thought the market was very good and government very bad, for Rothbard, allowing that the market falls short of perfection and government might do some good was unnacceptable.  And so, there were differences between them.   Rothbard defines fractional reserve banking out of the market, and argues that gold mining causes no problem.

Neither Mises nor Rothbard have any sympathy for a cost of production theory of value. They would insist that prices are determined by marginal utility and that opportunity costs are the only costs that matter.  (In my view, they downplay production too much in this context.)

They also understood that money is demanded as a medium of exchange.   In their view, the purchasing power of money depends on the quantity of money and the demand to hold it.   And people mostly hold money because it serves as medium of exchange.   (Pretty orthodox, really.)

Both Rothbard and Mises understood that changes in the purchasing power of money adjust the real quantity of money to the demand to hold it, simultaneously correcting any general glut of goods.

The reason why increases in the nominal quantity of money are a bad idea in their view is that they argue it causes the market rate to fall below the natural rate.   A reduction in prices and wages increases the real quantity of money without having that effect.    (What Mises thought on these matters is somewhat controversial.  Rothbard argued that any increase in the nominal quantity of money not backed 100 percent by gold forces the market rate below the natural rate, and that increases in the purchasing power of money do not result in any distortions.)

As for Hayek, he did argue that the ideal was constant nominal expenditure on output, so the nominal quantity of money should adjust to offset changes in velocity.   He didn't see this as a realistic policy proposal (ever?) and in the early years advocated the international gold standard.   He understood that the gold standard would not generate the "ideal."

Later, as a policy matter, he rejected accepting massive deflation if needed to stay on gold.    Reversing decreases in the quantity of money and increasing the quantity of money to offset decreases in velocity was the least bad option, in his view.

And finally, in his later life, he favored full privatization of money, and expected it to generate something like a stable price level.   The quantities of monies would likely adjust to offset both changes in velocity and changes in productivity to leave the price level stable.   While he said he expected that this would result in some market distortions, he didn't think they would be significant.   As with Mises and fractional reserve banking in the context of gold redeemabiliy,  Hayek thought that price level stability would limit and constrain any tendency of banks to push the market rate below the natural rate.

Ron Paul sees Mises as the font of all economic wisdom, but he is also influenced by Rothbard.  Since both Mises and Rothbard are dead, Paul is influenced somewhat by followers of Rothbard.    I don't know where Paul comes down on what distortions, if any, are created by mining gold under a gold standard, but I know that he is open to arguments that fractional reserve banking is fraud.

However, Paul's core political support combines elements of the libertarian movement and elements of the patriot movement.    The economic views of Mises, and Rothbard especially, are very influential in the libertarian movement.   (The views of the "Austrian" free bankers, and even monetarists, like Milton Friedman, are influential too.   In fact, most Market Monetarists, at the very least, lean libertarian.)

The patriot movement, however, has some views on monetary theory and policy that are very inconsistent with Mises and Rothbard.   One view is that central banking is about a conspiracy of international bankers to  earn unjustified profit from the issue of currency.   The element of truth to this is that early central banks, like the Bank of England and the Bank of the United States, were private.   They issued currency that paid no interest to fund loans to government and the private sector that did pay interest.   The private owners earned profits from borrowing at zero interest.   The government was using tax dollars to pay interest to the private owners of the central bank.

Why are the bankers earning interest on "our" money?   Today, the typical central bank is nationalized and whatever income they generate goes to the government.  The confused structure of the Fed, where the member banks do receive dividends, makes the Patriot theory at least a tad true, but only a tad.   Most of the income generated by the Fed goes to the Treasury.

Another Patriot theory is that credit money systems result in situations where there is not enough money in existence to pay interest on loans.   The quantity of money is equal to the principal of the loans.   The amount that must be repaid is the principal plus interest.   There is not enough money to pay back all of the loans used to create the money along with interest to the bankers.   Depressions occur when this problem manifests itself.   Debtors can't pay their loans because the monetary system doesn't create enough money to pay interest.   Generally, the lenders, trying to obtain more interest from borrowers than there is money available to pay, are villains.

Put this together, and the secret international bankers that own the Fed are profiting from issuing "our money," and their efforts to collect the interest leads to situations where there is not enough money to pay the interest and so people are forced into bankruptcy--losing their homes, farms, and businesses.   Often, the "patriot" approach harks back to "greenbackism," and insists that paper money should be issued by the Treasury to fund government expenditures and not lent into existence by the "private" Federal Reserve.  (Libertarians of all stripes dislike this approach.)

Anyway, there are self-described Austrian economic pundits, who are fans of Ron Paul, who spout confused combinations of Mises, Rothbard, and these patriot monetary theories.   I suppose that requiring 100 percent gold backing for currency prevents the secret bankers from profiting from earning interest and maybe even avoids this "not enough money to pay the interest" problem.

(I was a Rothbardian years ago.    I supported Ron Paul for President in 1988, 2008, and 2012.   I think "the fractional reserve banking is fraud," "the secret international bankers profit from issuing currency," and the "there is not enough money to pay all the interest" theories are absurd.    I don't think Depressions are about reallocating resources.   While I don't think excess supplies of money are desirable, I doubt whether they cause significant malinvestments.   I am certain that a monetary regime creating slow steady growth in spending on output would not create significant malinvestments, regardless of the changes in the quantity of money necessary to maintain the regime. )


  1. This is a great post, and I believe you have correctly stated the theories of Mises and Rothbard, highlighting the essential differences that make me a fan of the former and a critic of the latter.

    My only quibble is here:
    One view is that central banking is about a conspiracy of international bankers to earn unjustified profit from the issue of currency. The element of truth to this is that early central banks, like the Bank of England and the Bank of the United States, were private. They issued currency that paid no interest to fund loans to government and the private sector that did pay interest. The private owners earned profits from borrowing at zero interest. The government was using tax dollars to pay interest to the private owners of the central bank.

    I think much of this belief stems from the Austrian belief that money is non-neutral (not, as you say, a Patriot theory). Mises remarked (please don't ask me for a page number, ha ha) that because money is non-neutral, the first recipients, if you will, of newly created money-substitutes experience a total windfall, whereas by the time the money has had time to circulate a bit, later recipients merely experience inflation.

    So if the Fed increases the money supply by making banks its "first stop" for new bills, according to Mises' theory, those banks gain the aforementioned windfall.

    Correct me if I'm wrong, but *short-run* monetary non-neutrality is also an orthodox position. Therefore, I think this criticism of the monetary regime has real merit.

    I would certainly like the Fed to increase the money supply through me. They are certainly welcome to give me any amount of money they please, and I promise to spend it immediately to stimulate the economy. Why won't the Fed do that?

  2. Ryan:

    Thank you for the comment.

    The theories I described are common in the Patriot movement, and they do infect amateur Austrian commentary.

    On the other hand, some Rothbardians also treat banks as villains and some are inclined to conspiracy theory. However, Rothbardians tend to steer away from claims that paying too much interest to the money lenders is the problem. Rothbardians are very much focused on how banking makes interest rates too low.

    I do grant that they use the "who receives the money first," argument to claim that the inflationary process benefits bankers. The argument is confused.

  3. Off topic, but have you seen this video by Lawrence White? I think it's fantastic and should be spread as widely as possible.

  4. So Bill, you are comfortable backing Ron Paul for president, despite his avowed intent to "End the Fed" and institute a gold standard? Despite the fact that the single most pressing issue for America right now is whether it can get a better monetary policy, and Ron Paul is definitely a step in the wrong direction? As a certain Australian politician once said, "Please explAIN".

  5. Great post. I'd add that the Patriot Movement (not a presence here in the UK, obviously) seem to have ideas about money that are remarkably similar to Major Douglas and the Social Credit movement.

  6. "I do grant that they use the "who received the new money first" argument to claim that the inflationary process benefits bankers. The argument is confused."

    Confused how exactly? Are you suggesting that the Cantillon Effect is a myth? Or just that the specific argument from Rothbardians is flawed?

  7. I am no expert on what Cantillon said exactly.

    The inflation tax creates a revenue that can be directed towards certain products or provided as a transfer payment.

    An inflation tax requires no excess supply of money.

    If there is an excess supply of money, this could impact the allocation of resources. I doubt this is important.

    I don't think that the inflation tax particularly benefits bankers.

    I don't think an excess supply of money particularly benefits bankers.

    Any claim that the bankers get the new money first, or early, and so they benefit, is confused.

    Bankers are not "given" money as part of the process.

  8. Saturos:

    Ron Paul actually proposed that people be able to use alternative monies--the Hayek norm. I am all in favor of that, though I don't think it would make much difference as a practical matter.

    Paul also favors auditing the Fed, which I think is a great idea. I favor a complete shakeup of the Fed.

    Now, I do know that Paul favors a gold standard is at least sympathetic to the fractional reserve banking is fraud argument. I don't agree with either of those things.

    But I think Paul was much better than the alternatives on foreign policy, personal liberties issues like the Drug War, and I also agree with his view that the economic role of government should be greatly reduced.

  9. Bill, would you vote for Gary Johnson now? What do you think of him? (I suppose a lot of the GMU people would be voting for him, correct?)

    1. I supported Johnson for the Republican nomination in 2012 until he dropped out, and then switched my support to Paul. Johnson sought the Libertarian nomination and I supported that effort. (Paul for Republican and Johnson for Libertarian.) Paul did not succeed and Johnson did. I support Johnson for President in November.

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