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Money Creation

Now we get to the real reason Austrian economics can’t save us from the Keynesians.  Austrians know that Keynesian economics doesn’t really make sense.  Unfortunately they don’t know that Keynesian economics kind of makes sense.  It’s just that they Keynesians are not very clear about what they are really doing.  They give things misleading names and explanations and make assumptions that are not very good but end up leading to conclusions which are right in many ways.  I don’t know whether they do this on purpose or not but if they explained what was happening in a way that made sense I suspect many people would become very concerned about the way our economy actually works.  So, ironically, this task falls to me.

To put it simply, the Keynesian conclusions that printing money or increasing government spending can increase output in the short run are correct but only because the economy is constrained by the monetary system and doing these things temporarily relax this constraint.  They don’t magically create more wealth and prosperity, they just diminish the destruction for a while.  To understand this requires a careful modelling of the money creation mechanism.  So let’s start there.

Consider the market for loanable funds.  By this I mean the market for borrowing and lending money.  This is not to be confused with the market for savings and investment in a real sense.  This market is depicted below.  The horizontal axis is dollars and the vertical axis is the nominal price of borrowing a dollar, namely the nominal interest rate (i).  At higher interest rates, more loanable funds are supplied and less demanded (holding all other things constant).

Figure 1

In a free market with a money supply determined by nature (such as commodity money), the nominal interest rate would be determined as that rate for which the quantity supplied and quantity demanded for loanable funds are equal or i* above.

When the fed “prints” money, they don’t just drop it from helicopters into the economy, they lend it into the market.  At this point we have to choose a way to speak about the Fed’s policy goal.  This is actually a source of a serious misconception in Keynesian economics which I will get to later but the issue that confronts us currently is to either say that the Fed targets an interest rate and creates the appropriate amount of money to achieve it or to say that they target the money supply and let the market determine the interest rate based on that money supply.  At this point these two approaches are interchangeable, so it doesn’t really matter which we choose.  I will choose the former.  So assume that the Fed chooses an interest rate below the market rate.  Call this i’. Notice that they can only lower the rate by lending.  If they wanted to raise it above i*, they would have to become net borrowers which would mean they would have to create a new kind of security that as far as I know has never existed so it is safe to say that the Fed always sets rates less than or equal to what it would be with zero money creation.

At the target rate, the quantity of loanable funds demanded is greater than what is supplied.  In other words people want to borrow more at this lower rate but they want to lend less.  This is why this rate is not an equilibrium with zero money creation.  However, the Fed can solve this problem by simply printing the money and lending it.  In other words, they allow people to borrow money that nobody was willing to lend.  Thus the new money created is equal to the amount of the shortage in the loanable funds market.

Figure 2

Now my hypothesis, as I have tried to explain in the past, is that it isn’t really the interest rate which the Fed targets (or at least it shouldn’t be).  The problem is that they need to keep the money supply growing at an increasing rate.  If the money supply stops growing fast enough things fall apart.  I won’t try to convince you of this here just go along with it for now.  You can read some previous attempts though [1] [2].  This means that the shortage in the loanable funds market must be growing at an increasing rate.  There are essentially two ways it can grow.

The first way is if the Fed lowers the target interest rate.  This is what Keynesians call “monetary policy.”  If you lower the rate, holding supply and demand constant the shortage gets larger as in figure 3.

Figure 3

The other way is for demand to increase or supply to decrease (often the line between these two things is not very clear).  This would happen because of a change in the real economy, and would cause the shortage to increase as in figure 4.

figure 4

Just from thinking about monetary policy in this way we notice several things.  For instance, if the real economy is growing, the demand for loanable funds is likely increasing and the shortage is increasing at a constant nominal interest rate.  This is essentially what Keynesians count on during expansions.  If the economy is growing fast enough, they may even need to increase rates to keep the money supply from growing too fast.  On the other hand, if the economy is not growing fast enough, they would need to do something else to keep the money supply growing.

The most obvious approach would be to lower interest rates.  This works as long as interest rates are high enough to lower.  If you lower them all the way to zero though you can’t lower them any more.  This is the Keynesian liquidity trap but with a different explanation.  Instead of being able to increase the money supply without changing the interest rates, they are unable to change the money supply because they are unable to lower interest rates.  (Note that by “money supply” I mean the broader money supply not just base money) If this happens they must do something that changes the supply or demand for loanable funds.  In Keynesian economics they call this “fiscal policy.”

By far, the simplest solution to this problem is to have the government borrow more.  This increases the demand for loanable funds directly which increases the shortage and allows the money supply to grow.  It doesn’t matter what they spend it on, it is the monetary effect that is important.  This effect can exist along side the “broken window” effect.  This is what Austrians don’t get.  The wasteful effect of government spending is the Scylla to the Charybdis of monetary collapse.  It’s not that Scylla is good, it’s that the alternative is even worse.

Another alternative is to convince people that future inflation is coming.  This also increases the demand (and/or decreases the supply) of loanable funds, increasing the shortage and the money supply.  In the short run, this is a self-fulfilling prophesy because the new money will raise prices, causing the expected inflation to materialize.  Whether or not this is sustainable indefinitely is an open question, although I contend it is not.  At any rate this is why you see the Fed going out of its way to look like they have additional “arrows in the quiver.”

Finally there are a number of policy options that can cause an increase in the shortage without the government borrowing directly.  Chances are you would have never thought of these policies in this way but they provide a powerful part of the explanation for how this system has been able to go on for this long and present a frightening picture of how deep into this we are and how little is left to support the continued growth of money.

In the thirties, the government created Fannie Mae (and later Freddy Mac in 1970) “to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities.”  Translation: to make it easier for people to get home loans thereby increasing the demand for loanable funds.

In 1935 the government created social security and in 1965 expanded it and added medicare.  These programs take money from workers when they are under 65 and pay it back to them when they are over 65.  This money goes into the general fund and is spent on whatever the government wants rather than saved/invested for the purpose of paying future benefits.  The expectation is that the future benefits will be paid out by future workers.  The effect of this is that workers don’t save as much (possibly nothing at all) in expectation of these future payments and this reduction in private savings is not offset by any increase in public savings.  In other words, the supply of loanable funds decreases which increases the shortage.

Unemployment insurance (also originating in the 30s) removes the incentive to save “for a rainy day,” thus decreasing the supply of loanable funds.

Federal student loan programs encourage people to go to college by borrowing money, increasing the demand for loanable funds.

The Dodd-Frank bill lowered the fees banks could charge on debit cards, making credit cards more profitable and leading to more incentives for people to use credit rather than debit cards.

Of course this is a very abbreviated list.  These examples go on seemingly without end and once you start thinking about things in this way you will notice them all over the place.  One result of this is that we treat waste as production because waste causes additional demand for money.  Another is that we are now a highly leveraged society and getting more so all the time.  Just as anyone whose life is financed by debt our reality will come crashing down around us when we run out of equity to leverage.  The man who finds himself in this situation is often surprised to learn that he doesn’t actually own anything.  We would do well to realize it before that point.

  1. December 27, 2011 at 9:33 am

    I think this is your best one that I’ve read so far. You should do some more work on this. I see a professional paper in the works here. The graphs really helped me understand it. I’ve noticed you are writing a lot more recently. Is this for your students or still just for fun?

  2. December 27, 2011 at 9:48 am

    Also, I have read your article twice and I have a few questions:
    1. What are the effects of “… allow(ing) people to borrow money that nobody was willing to lend”? Bad loans, malinvestment, unemployment, foreclosures, etc?
    2. Are you saying that the “money supply must be growing at an increasing rate” in order to keep interest rates at the target? This makes sense intuitively, but I wanted to make sure.
    3. What does it mean that this shortage is always increasing? Does that mean that none of us really own anything?
    4. Does this ignore people’s expectations of inflation? How would expectations alter your conclusions if at all?
    5. Doesn’t this necessarily mean that the Fed raising its targeted interest rates in 2006-07 in of itself created the Great Recession? What would the effects of raising interest rates be now?
    6. Is there even really an economy in the United States anymore? I feel like this analysis means that the United States is a huge bubble economy, even in the midst of a massive recession. Is this unreasonable?

    Sorry for all the questions. It was truly an impressive read. Even at 2:00 in the morning.

  3. Free Radical
    December 27, 2011 at 7:39 pm

    Thanks, I fully intend to do more with this, it’s part of a larger model I’m working on. I’m posting more because I’m not teaching right now. I had 3 classes last semester so I was pretty busy. I’m glad the graphs helped it was quite an ordeal figuring out how to get those into the post, I’m developing my blogging skills though.

    Since it is part of a larger model, it doesn’t explain inflation expectations, although I linked to a couple previous attempts at explaining them. They are of critical importance because they are the real reason the money supply must continue growing at an increasing rate. This is because people’s decisions are based on certain inflation expectations and if inflation is lower than what they expect they are screwed because they can’t pay off their loans (which are nominally denominated) when prices go down. So it is not to keep interest rates at the target it is to keep inflation rates at the target.

    This model is independent of malinvestment explanations. It neither relies on malinvestment nor contends with it in any way. I’m sure there is some malinvestment associated with our monetary system but I don’t believe this is enough to explain it by itself.

    It’s always too simple to say that the Fed raising rates caused a recession. It’s possible that setting the target rate too high causes inflation to fall short of the target and brings on a recession but to say that setting the rates too high caused it presupposes that if the Fed sets rates correctly we would never have a recession. Since what I am trying to show here is that the recession is inevitable because you always eventually enter a liquidity trap, the strongest thing I would say about any particular move is that it brought on a recession sooner than was necessary.

    The effects of allowing people to borrow money that nobody was willing to lend are that prices go up in the short term because people use this money to bid up the prices of goods and services. In the long run you have a conflict between inflation and real interest rates that is not so easy to resolve. But the most important thing is that this borrowing does not represent a debt from one citizen to another it represents debt owed by the people to the Fed. This means that if something happens to cause them to default the property collateralizing that debt belongs to the Fed (or whomever the Fed decides to redistribute it to….usually Goldman Sachs). And what’s more, the Fed controls the forces which can cause everyone to simultaneously default (deflation). So we are in a situation where we face the constant spectre of deflation wiping out all of our wealth (“all” is an exaggeration of course but it’s a lot) and the only way out is to get more in debt. If we aren’t willing to go more in debt individually, the government puts us more in debt collectively and in the process buys up larger and larger portions of the real economy. If we keep doing these things to put off the catastrophe, then the catastrophe will come when we have nothing left to leverage or in other words when we don’t really own anything any more. Obviously some people will still own things who didn’t live off of debt but these property rights will become highly questionable when the system falls into the kind of turmoil that would necessarily accompany such events. Even if there are no riots and revolution the government will most likely come after the wealth of these people in the form of taxes in order to pay down the gigantic public debt.

    If I didn’t wan’t questions I wouldn’t have a blog. (=

  4. December 28, 2011 at 9:30 pm

    haha keep it up. This was my favorite post so far. It seemed like something I would see in a really good economics textbook. I want to see it refined and published. I think you are on to something pretty big here.

  5. Free Radical
    December 28, 2011 at 11:23 pm

    Thanks, me too actually…

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