Re: It Was the Fed's Fault (and His) (#128680)
by Bill Woolsey on November 4, 2008 at 9:41 AM

I think there are two sensible ways to look at macroeconomics. With either approach, we can explain how it isn't necessarily Greenspan's fault.

One approach looks at the natural and market interest rates. The natural interest rate depends on saving and investment--time preference and expectuations about the profitablity of purchases of capital goods. If we assume monetary equilibrium, then the market interest rate is always equal to the natural interest rate.

(In Rothard's version of Austrian monetary economics, the market interest rate equals the natural interest if the quantity of money changes with the supply of gold. I don't agree with either that approach or the slightly more sensible one that has the market interest rate equaling the natural interest rate if the quantity of money is unchanged.)

In the absence of monetary equilibrium, market interest rates can deviate from the natural interest rate. By creating monetary disquilibrium or correcting monetary disquilibrium created from other sources, a central bank can manipulate market interest rates. They cannot control market interest rates and maintain gold convertibility, the foreign exchange value of the currency, the price level, unemployment, or anything else. Those who claim that international capital markets limit the central bank bascially assume that there are limits to how far the central bank will allow the foreign exchange rate to change. The only absolute limits is that nominal interest rates can't fall below the cost of storing currency (without getting really fancy with currency reform) The other limit is for people to stop using the currency-- a hyper inflationary crack up. Or for the quantity of the monetary base to fall to zero. If there is none of the money the central bank controls or else it is worth nothing, there is no market interest rate in terms of that money.

Anyway, if the natural interest rate fell, perhaps because the Chinese saved a large portion of their growing incomes (global savings glut,) then keeping the market interest rate equal to the natural interest rate requires the central bank to lower its target for the interest rate. If the central bank failed to do so, it could keep market interest rates above the lower natural interest rate by creating monetary disquilibrium. The market process that would correct this would be deflation. (Though with a inflation target of 2%, that would actually be disinflation.) By continuing perverse intervention of maintaining monetary disquilibrium the central bank could stubbornly keep the market interest rate above the natural interest rate.

The other way of looking at matters is the supply and demnad for money. You can use whatever measure you want, but always remember that the financial intruments you don't count as part of the money supply are going to be impacting money demand as close subsitutes.

The amount of money people choose to hold can change. A central bank can adjust the supply of money to match that demand. During the ninties, there was a large drop in the M1 measure of the money supply. There was no deflationary crisis, presumably because this change in money supply was matched by a decrease in money demand. (Perhaps people were instead holding other financial instruments that are not counted as being part of the money supply using this approach.)

Anyway, if the money supply is adjusted to money demand, then interest rates depend on supply and demand for various credit instruments. These supplies and demands reflect time preference and expectations of future profitability.

To make a long story short, there is no way to look at interest rates or meaures of the money supply to determine whether a central bank has somehow managed to get it right.

This is especially true of expremely narrow measures of the money supply, like the monetary base or bank reserves.

In my view, the demnand for bank reserves dropped off rapidly during the last decade. It was caused by a decease in the supply of checkable deposits. That decreae in the supply of checkable deposits for the most part matched a decrease in the demand for checkable deposits (because many people were able to hold funds in savings accounts at night when these things are actually measured due to the introduction of sweet accounts.) The supply of bank reserves dropped.

However, if the Federal Reserve failed to decrease bank reserves enough, then there was an excess supply of money. That is, the Fed failed to prevent monetary disequilibrium created by a switch from checkable deposits to other sorts of financial intruments.

I believe that the Henderson/Rummel article failed to emphase the importance of redeemability between vaious sorts of money, which is how control over the quantity of base money allows a central bank to maintain control. However, the other side of that coin is that there is no particular reason to assume that it isn't necessary to decrease the monetary base to prevent inflation. The demand for "money" given this narrow definition, could easily fall. And, if that occured, I would expect that market interest rates would be below the natural interest rate. That is, there is too much money and interest rates are too low... Because the central bank failed to decrease base money enough.