Home > Macro/Monetary Theory, Uncategorized > The Argument Gary North Has Been Waiting For Since 1933

The Argument Gary North Has Been Waiting For Since 1933

The nice thing about patronizing a not-so-popular blog: you get a lot of individual attention.  “Anonymous” (a very popular name here in the blogosphere…) directed me to this post by Gary North so I thought I would address it.  Here is the heart of his argument:

. . . (I)t is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices.

Before digging into this, let’s establish a few points about monetary theory.  The main reason there is so much disagreement about monetary economics is that it is very complicated and because it is very complicated, there is essentially no general model of an economy which includes a detailed modelling of the type of monetary system we currently have.  So when people talk about monetary economics, they have some model in mind.  But that model is an attempt to isolate one piece of a larger machine.  This forces you to make assumptions about the interactions between that part and the rest of the machine and your results depend heavily on these assumptions.  It is like making a model of the knee.

You may say that flexing the quad muscle straightens it and flexing the hamstring bends it and this may make perfect sense but there is always a set of assumptions underlying the model.  For instance, if you are in a harness suspended from the ceiling, then flexing the quad is not required to straighten the knee, it is only necessary to not flex the hamstring.  If you are hanging upside down, the opposite will be true.  If you are sitting on a dock dangling  your feet over the edge then you will need to flex your quad to straighten it if it is bent less than 90 degrees but not if it is bent more than that (and vice versa for bending it with the hamstring).  The original model where the quad straightens and he hamstring bends is based on the assumption that you are suspended in the void of space far from any gravitational forces or that you are, for some reason, experiencing resistance in both directions which perfectly cancel each other out at all points of your knee’s range of motion.  Probably this is not often the case.  And all of this does not even address larger questions like: if you want to move in a certain direction should you bend or straighten your knee, or where do the signals that tell your muscles to flex come from?

The bigger your model, the better your understanding of the specific part.  A model of the whole body tells you more about how the knee works than a model of only the knee.  Put this into a general model of physics and you understand even more.  Unfortunately, with our current monetary system, this is pretty difficult to do for various reasons which I won’t get into now, so we try to take pieces and analyze them in isolation.

This is a very useful way to gain some understanding of a complex system.  But the problem is that most people involved in the internet food fight (probably even occasionally yours truly) take their assumptions for granted and when they run into someone with a different model with different assumptions they accuse them of not understanding economics.  Of course, in many cases this is true but it doesn’t help to just say this, you have to try to understand why their model gives different results and then attack the specific flaws in assumptions or reasoning which lead to these results.  This is what North is telling you to do (“look for a theory”) but he’s not giving it to you.  He isn’t explaining the theory he is using.  So I will do this for you.  Since after all “If you do not understand the case (he has) just made, you will not understand any refutation.”

This is a very standard monetary model.  There is a certain quantity of base money determined by the FED.  Call this M0.  This goes out to people somehow (dropped from a helicopter or something).  They take the money and put it in the bank.  The bank is required to hold a certain amount as reserves.  Call this amount R.  The rest (1-R)M is lended to others who spend it and the people who receive it in payment put it in the bank.  The bank then keeps a proportion R of that money and lends the rest and the cycle continues until all of the base money is in the bank and the bank deposits which are supported by this will be (1/R)M.  This (1/R) is known as the money multiplier.

So North’s argument essentially boils down to this: the FED controls base money (M0) and it controls the money multiplier through the interest rate/penalty on excess reserves, therefore, it completely controls the money supply (deposits in the example above).  But there are a number of assumptions which go into this which are problematic.  For starters let’s examine the notion of “hoarding” cash which he addresses.

In reality, all base money does not end up in bank accounts, people hold some amount of cash.  We can account for this by amending our model slightly.  Say that the first people who get the helicopter money hold a fraction C of that money as cash and only deposit (1-C)M in banks and subsequent iterations of people do the same.  Then the money multiplier will be (1+C)/(R+C).  This means it will be lower than if they deposited it all in the banks.  And the larger the amount of money they keep, the smaller the money multiplier will be.

So when North says ” If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks.”  He completely misses the point of the possibility for deflation from currency drain.  He is coming to the conclusion that it is impossible by assuming that all the “hoarders” spend all the money they are supposedly “hoarding” and that whoever they pay it to will deposit it all.

So he is right that you can’t go out and cause a deflation by withdrawing cash from the bank and spending it.  But you can do your small part by keeping more money in your wallet on average and less in your saving/checking account.  Obviously, if you do this alone, the effect will be miniscule but if, for some reason, lots of people decided to hold more cash and put less money in the bank, this could have a noticeable effect on the money multiplier.

So why would people do this?  Well this ultimately takes us far beyond the knee but to address the question to some extent, we must ask why people hold cash and why they put money in the bank.  The assumption underlying North’s argument is that people only took money out of the bank and held it as cash because they were worried about losing it.  This is why he thinks that FDIC insurance solves the problem once and for all by removing this fear.  But people still hold some amount of cash.  This is because cash is more convenient than bank deposits for some purchases.  This is essentially what Keynes called the “liquidity preference.”  So if for some reason, liquidity preference increased, people would hold more cash and the money multiplier would decrease.  I won’t go into why this might happen but rather be content to point out that North has done nothing in his post to prove it is impossible.

Now let’s look at the more important shortcoming of North’s argument.  He is assuming (implicitly) that the banks can always lend as much as they want, they are just choosing to hold excess reserves because the rate on those reserves is too high (not negative enough).  Technically, this may be true.  Certainly, they could lend any amount of money if they lowered rates low enough.  The problem is that they might have to lower rates below zero which is not really possible.  It is perfectly possible that banks may not be able to lend all of their excess reserves at a positive interest rate if demand for bank credit is low enough.

North asserts that the money multiplier is a matter of FED policy because they set the rate on reserves and they can charge a penalty on reserves to force banks to lend them if need be.  But even if this is true and banks can’t avoid them by keeping reserves in cash rather than accounts at the FED, how will the banking system survive when the FED charges such a penalty and this drives interest rates down to practically zero without generating a quantity demanded of bank credit large enough to exhaust excess reserves?  Banks don’t make anything on loans and they have to pay the FED for holding the funds they can’t lend.  In other words, banks go broke.  This is not a long-term solution.  Some may say that this is okay because it isn’t a long-term problem.  I disagree but won’t say any more on that subject here.

Suffice it to say that this is precisely what my model says will happen in a deflationary crisis.  This will happen because when interest rates get near zero, the FED’s ability to inflate the price level is largely diminished.  This leads to inflation which falls short of expectations (notice it need not be deflation at this point).  The failure of prices to rise to the expected level means that many people who took out loans in the past in expectation of the nominal gains which go along with inflation are not able to pay off their loans.  This causes a wave of defaults which, along with a decrease in expected inflation, causes a general decrease in demand for bank credit and a subsequent collapse in the ability of the banking system to sustain the credit structure with current interest rates.  And of course the FED can’t lower rates any more because they are already near zero.

This is exactly what happened in 2008.  You can wring your hands and say “well prices didn’t actually fall” but that is completely beside the point (Note however that in his graph the money supply, though it is increasing after 1933, it does not reach the 1929 level until 1939.  How do you think prices in 1939 compared to expected 1939 prices in 1928?) .  Price inflation fell short of expectations, rates were near zero, excess reserves were high and prices would have dropped precipitously and there would have been a credit melt-down had it not been for “extraordinary” and “emergency” measures taken by the government and the Federal Reserve to prevent it.  This is what everyone said at the time.

It is also essentially what happened in 1929, though some of the details were different–mainly because we were on a gold standard.  My position is not that when these things finally come around, there is nothing the government can do to stop prices from falling.  It is that the things they would have to do to stop it would be undesirable to people who appreciate things like liberty and small government.  And this is exactly how it panned out in both of those cases.  As these contractions continue to happen, the “emergency” measures will get more and more “extraordinary.”

P.S. The case of the Weimar Republic is one with a completely different monetary system, just as I mentioned in a previous post.

  1. Steve
    August 8, 2012 at 6:58 pm

    Thank you for addressing North’s article in so thorough a manner. Though he is getting old I do believe he will live long enough to witness the refutation of his arguments by reality itself. I wonder what Mises himself would say were he still alive? The current generation of Austrians all seem to interpret his work the same way. I foresee a frantic scramble in the near future as they try to fit the coming deflationary environment into their current model.
    I think this will be good in the long run for Austrian economics though. Once they’ve wiped the egg from their faces and figured out their mistakes, they’ll regroup and hopefully have some influence in the rebuilding of a better financial system.
    With regards to cash, I don’t think its importance can be overemphasized. Consider this; if every man, woman and child in the USA suddenly decided to keep a mere $1,000 in currency at home, there would be NONE left in bank vaults, business cash registers, or even the FED warehouse. The Fed ‘only’ prints about $400 million per day. To increase this to meet a sudden increased demand would require the reintroduction of notes with larger face values of $1,000 or $10,000, (or greater). The Fed warehouse contains $70-$90 Billion (a 1/2 year reserve based on current demand). A sudden shift in people’s liquidity preferences could easily create panic and a run on banks. The idea that the existence of the FDIC forever prevents this from happening is absurd.

  2. Free Radical
    August 9, 2012 at 1:58 am

    No problem, thanks for commenting. Blogging is supposed to be about having discussions after all. I didn’t get into this in the post but as far as liquidity preference goes, interest rates are a big part of the equation since people will hold cash until the liquidity premium is equal to the nominal rate they could get by putting it in the bank. So when interest rates are low, the cost of holding cash is low which is likely to cause an increase in the currency drain rate. However, it’s also true that if prices start to fall, peoples’ real cash balances (M/P) increase automatically for a given nominal amount of cash holdings so this would have a mitigating effect. At any rate, I don’t think this will be the main cause of the deflationary pressure, I just wanted to address that North’s point about all cash remaining in the bank no matter what is erroneous.

    Regarding Austrians, I fear that they will never come around. And I say “fear” sincerely because philisophically I think they are the closest school to what I believe (though I just discovered the free banking school which looks promising). But they have largely eschewed any sort of rigorous mathematical analysis in theory or statistical analysis in observation. This means they always seem to find a way to avoid realizing that their theory doesn’t make sense or their expected results are not occuring. A perfect example of this is North’s insistence that 2008 is somehow a refutation of “deflationism.” To be fair I’m not exactly sure what that is even though I seem to be one of them. I sort of came to this on my own (I’m actually an industrial organization kind of guy by day) so I’m not sure what arguments other so-called “deflationists” have made, though I’m looking into it. If you enjoy seeing Austrians get fed to the lions, you should read this post.


    I think it very clearly (at least if you’re an economist…) demonstrates why Austrians are lost in the woods at this point. It would be very interesting to see what Mises would say if he were around. I think the old school Austrians were on the right side, it’s just that the world has left them behind and their successors have been unable to keep up with the system we have created. (I especially think Hayek was brilliant even though real Austrians consider him sort of a half-Austrian).

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