I’m shocked by the general lack of understanding regarding monetary theory and policy. Especially because most of the confusion seems to be coming from conservatives and hard money advocates. Why so much confusion? Well, as the old adage says, "a little bit of knowledge can be dangerous.”


Let’s look at inflation as an example. Most would agree that inflation is an increase in the money supply which leads to a general increase in prices of a nation. This in fact is the Webster's Dictionary definition. This definition is true, but it is also simplistic and more of a description than a theory of money and credit. There are two competing theories on the subject. One is the Quantity Theory of Money made famous by Irving Fisher and championed by Milton Friedman in later years under the name “Monetarism,” and the other is the Subjective Theory of Value as posited by Ludwig von Mises of the Austrian School of Economics. One ascribes an increase in the general price index to an increase of money and the other holds that it is what individuals do with money and how they value it that pushes prices up or down. The last four years are an argument for the Mises proposition being the more accurate of the two theories.


After all, the Fed has increased the money supply more in the last four years than at any time in history, but the inflation rate, regardless of which method you use to measure it, has remained stable. That’s because the new money created remained in the banking system and has never filtered through the economy. The fear of inflation and the vilification of Fed policy had nothing to do with fact, but everything to do with fear and misunderstanding. The acceptance of the Quantity Theory of Money, which claims that an increase in the money supply is automatically inflationary, is one reason. Since the Fed has embarked on quantitative easing, the quantity of money hasn’t determined the value of money; individuals and how they value a medium of exchange and their subsequent decisions to hold money or dump it has been the determinant of prices. This distinction has been lost on many of our best and brightest.


Take the hard money camp. For the most part they’ve been predicting a great inflation as a result of the huge increase in money supply. But calculate prices in terms of gold—their favorite money—and prices have actually fallen dramatically. Gold today at $1600 buys substantially more than it did at $1000 four years ago when the Fed began quantitative easing. If real money is gold as they claim, then we’ve been witnessing deflation. An increase in purchasing power is the definition of deflation, not inflation. Claims that huge new money creation by the Fed would lead to a massive act of theft through rising prices simply haven’t materialized whether calculated in dollars or gold.


The strong constituency against the Fed printing more and more money, as put forth by Milton Friedman during the inflationary 70’s, was correct when the Fed was blatantly abusing its power. In those days, credit expansion was rampant.  Today credit expansion is almost non-existent. Monetarists called the Fed on its monetization of debt when it artificially created and then pushed money into the hands of people and enticed them to spend. In the 1970’s governments held down interest rates, promoted easy credit, and increased the money supply progressively. This led to progressive inflation rates and undermined confidence from consumers who after seeing prices rise year after year began to rightfully distrust the value of their money. Dishoarding of money resulted, the dollar dropped sharply, and prices began to rise from 2% to 4% to 8% to 14%.


The monetary increases never stopped until Paul Volker was put in charge of the Fed and he stepped in to stop the inflationary spiral by stabilizing the money supply. Volker allowed interest rates to seek their own level which soared to over 20% to compensate for inflationary expectations. With the increase in real interest rates, people immediately stopped borrowing and started saving; they began hoarding dollars rather than dumping dollars. The dollar stabilized, and the money supply rate fell prompting a decrease in the inflation rate and interest rates progressively year after year. It is the dishoarding of money that leads to inflation, and hoarding of money that leads to deflation.


Unlike the inflationary era of the 70’s which was characterized by a progressive increase in money supply, a falling dollar, and rising prices due to more money chasing goods; today cash is king. Individuals are seeking the safety of cash and cash equivalents, and the price of money reflects this fact as interest rates have plummeted while the dollar has firmed. The Quantity Theory of Money has been proven incorrect in today’s context.


Monetarists were right in their analysis in the 70's but their analysis became outdated in later years. Monetarism was not a theory for all seasons. Yet many conservatives and gold bugs are still monetarist today, despite the theory being inadequate for over thirty years now. In an era characterized by a flight to cash and almost zero credit expansion many are still calling for tighter monetary policies. But a monetary policy that would reduce money and credit in this economy would no doubt lead to deflation and depression, or at best, something like a thirty year replica of the Japanese economy.


Let me be clear, it is true that an increase in money can cause inflation. But it is not true that it must. Sometimes an increase in money is anti-deflationary. This is one of those times where an increase of money has not been met with an increase in dishoarding and increased spending. Monetarism makes the fundamental mistake of assuming that if the money supply increases, the money will chase goods. Ludwig von Mises argued against that notion and held that it was what individuals did with money that determines prices. This theory continues to be proven daily.


I seriously doubt that most who espouse Friedman’s view of monetarism, ever read Irving Fisher’s original treatise promoting his quantitative theory of money. Yet, policy is being advocated and the Fed maligned based on that theory. And this is coming from both the Left and the Right.


In economics, it is context that determines outcomes. One of the reasons economists invented the term “all things being equal” is to theoretically establish context. They attempt to prove a point where change does not exist. That’s all well and good when trying to make a theoretical point, but since change occurs daily, a theory that ignores it in reality, is not a very good theory. This is why things were so different in an era that saw the dishoarding of money compared to today when people are clamoring for it. Context and human action is why results are completely different today than in the 70’s, and why deflation is now more of a threat than inflation. If all things were as they were in the 70’s, we would have inflation. But they are not. Things are very different today. A lot of people still have not figured this out.


I think it is obvious that Ludwig von Mises properly identified the cause and consequences of inflation. He identified the axiom of human values and human action as being the root of all economic consequences. I trust that scholars years from now will credit Milton Freidman for educating individuals about the harm a runaway Fed can do to a nation. But I believe it is von Mises who will be hailed for his accurate theories on money and credit that explain the monetary conditions today. The events of this decade settle the argument of Fisher’s quantitative theories of money and credit versus Mises’s value oriented analysis once and for all. Further proof that economics cannot be reduced to a slogan and that bumper sticker economics is a dangerous way to guide the policy of nations.


Yet, that is what we have today. Overly simplified and inaccurate bumper sticker style slogans like “End the Fed” and “the Fed is destroying the dollar” are just some of the erroneous statements accepted as truth today regardless of the evidence. Another such bumper sticker phrase circulating on the internet lately is ironically a quote by Ludwig von Mises using his terminology, “the crack up boom.” The phrase is being used by conservatives and gold bugs to warn of a Fed induced monetary increase and a subsequent artificial boom to be followed by monetary and economic collapse. We are to believe that von Mises himself were he alive today would be predicting an imminent monetary and economic collapse.


Again, I have to assume that those citing this concept by Mises have never read his entire work. The “crack up boom” referred to a specific set of conditions within a context that projected cause and effect in a society where government was progressively increasing the money supply in order to progressively stimulate the economy. The “crack-up boom” isn’t inevitable in today’s world, and certainly isn’t the result of anything the Fed has done in the last several years. How could it be, when there has been no progressive monetary and credit expansion, no progressive economic stimulation, and no artificial boom?  Those that cite this theory would do well to read The Theory of Money and Credit by von Mises and also his treatise on Human Action before citing it in error again.


See my 2010 article The Crack-up Boom.


The quantity theory goes much further than just attempting to predict inflation; it attempts to predict human action. For example, many gold bugs predict the price of gold based on the money supply. They assume that you can divide the amount of money (X) by the amount of ounces of gold and determine its price. This is not true, and never has been. The price of anything is what individuals will pay for it. Prices are market determined. Market determined means it is the values of individuals, not mathematics, that establish price. If gold is fixed in price substantially above or below its market value it will not be the standard which it is hoped to be. In that scenario, gold would be as fiat as the un-backed paper dollar. Gold’s value is what it will buy in the open market, and that is all.


The quantity theory of value is a mathematical formula. It attempts to define for everyone what everyone ultimately must define for themselves. This is why I argue against imposing a fixed exchange rate system, or a gold standard on a society that has not been able to live within its means. It would be more than futile – it would be dangerous. Yet, this is what most gold advocates and many conservatives advocate today. They believe that fixing the price to gold would be a panacea. It would not. A fixed price of gold may be a good idea someday, but not today.


As much as it pains me to say so, neither Mitt Romney nor Paul Ryan correctly understand monetary theory. I believe this because they are both monetarists at heart. The same is true of most free market advocates and gold bugs. Amazingly, many today who claim to be Austrian School disciples, preach monetarism, a theory that von Mises and Austrian economists fought so hard against.  How unfortunate that people who understand sound economic theory are so wrong when it comes to monetary theory.


As part of a handful of free market advocates who’ve argued that it isn’t inflation we have to worry about, or the Fed—I’ve been roundly criticized as someone who doesn’t understand the situation.  But this criticism comes from those who have never read or don’t understand the monetary theories of the great masters. I don’t say that as a slight against my critics, but rather to encourage them to delve deeper into past theory before they try to influence modern monetary thought and policy. Because if there isn’t a more accurate understanding of our present monetary mess in the next year or so, the resulting damage to this nation could be huge.


Likely the Fed will change greatly when Ben Bernanke leaves, which may be announced in the fall of 2013. If the new Chairman is someone like Janet Yellen, the current Vice Chairman, we’d most likely move toward an easier monetary policy. That wouldn’t be all that dangerous since everyone knows all about inflation and how to defend against it. But if the new Chairman were a monetary hawk bent on tightening monetary policy, things could get much worse than they are today.


Look at Europe for an example of rigidity. The conditions in the euro zone were brought on by too much debt, but they were made worse by strict austerity together with rigidly tight monetary policies. Tight money mixed with austerity is a recipe for disaster when facing a recessionary/deflationary trend. Fiscal and monetary discipline is fine, but when applied in times of fragility can exact a price greater than the reward. While I agree with most everything Romney’s economic program has to offer as solutions to our nation’s problems, his monetary theory scares me. People point to the deflationary depression in housing as proof of this Fed’s failure. But had the Fed had not pursued an aggressive monetary policy to prevent a massive contraction of the money supply, even greater de-leveraging, and an even worse collapse of housing prices, the US would no doubt be in a full-blown deflationary depression today.


The Fed together with the Treasury fought to preserve the financial system as we know it – and did. There are those that argue they should not have. The world would be a much different place today if they had gotten their way. Fortunately they did not – but they might soon. And do so in the name of monetary and fiscal discipline.


All my adult life I have fought for sound money and fiscal responsibility. Even still, I do not endorse the bumper sticker economics and catch phrases that declare, "End the Fed,” or "Stop Printing Money,” or even "Back to Gold!" Despite sympathizing with these views, I’d like to end by amending another age-old adage, “all in good time.”


We must make these changes all in the correct time.

Paul Nathan
August 20, 2012

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