The Art of Central Banking

This is not about a book I wish I could have..

This one is a risky one.

I will question “everything”.

I will question the fundamental “fundamental propostition of monetary theory”, first stated by Keynes then by Friedman and afterwards greatly explained by Leland Yeager.

I will also question Nick Rowe, who is the champion of monetary disequilibrium analysis nowadays (and probably my favourite blogger).

Hell… I will even attack one of my favorites Classical Economists, Claude-Frédéric Bastiat.

(I can get off my high horse right now, I will not dispute anyone, just try to add something – except for Bastiat)

I do believe money is special. Money is the medium of exchange. The fundamental proposition of monetary theory is true. The supply of money (unlike other “goods”) determines its demand and therefore its stock. (this sentence doesn’t contradict the “endogenous money” theory, but that is for another day)

But I do believe Central Banks somehow have a higher level of “specialness” than money.  (Well, if I am trying to be “against” so many great economists, this one will also go against George Selgin and the Free Banking School also).

So, how would I do that?

I will tell a story of course!

Imagine a society. Workers, producers, capitalists, everything normal.

The medium of exchange is fiat money, created by the Central Bank at its own discretion.

We have full reserve backing, therefore banks are not “creators of money”.

The Central Bank has a mandate to keep prices stable, it issues money when deflation is expected. It destroys money when inflation is coming. Assume no productivity shocks.

But this Central Bank has a peculiar way to conduct monetary policy. It buys/sells art. Yes, the Chairman is a very sophisticated guy.

Paintings are generally produced and traded amongst citizens, but every once in a while Mr. Chairman buys a new panting and prints new money. (We can assume that paintings’ value will increase as time goes by, so it’s a type of seigniorage that increases CB’s capital).

Somehow, one day there was a change in “animal spirits”, increasing the general demand for money. As the money stock remained constant, Walras Law states that the excess demand for money will be reflected in an excessive supply of goods, a recession.

For simplicity, we will assume that poor old Joe the Window Maker, was the only one affected by this glut. To stop the Keynesian multiplier on its beginning, I assume that the general increase in money demand “only eats up” the desired saving of Mr. Joe, by allowing him to work only enough to keep his consumption stable.

Therefore we have an increase in unemployment. It’s not a big increase (only less hours worked for Mr. Joe, I could complicate the story but I won’t).

Up high in Valhalla, Thor was being annoyed by Claude Bastiat. He was continuously stating that Norse Gods worship was a waste of his time and therefore THEFT!

Thor just to annoy Bastiat released a thunderstorm that destroyed the big and beautiful Vitrail of the Central Bank.

Mr. Chairman despaired and as the Vitrail was essential for the Central Bank credibility, hired Mr. Joe to repair it.

As it charged 100 units, Mr. Joe was confronted by an embarrassed Chairman saying the rolling press was temporarily malfunctioning (talk about credibility) and therefore it would have to pay him with one of his paintings. He showed him how nice was the painting, but Mr. Joe was suspicious.

Mr. Joe was a simple man, but not stupid. He called his friend Vincent, the Art dealer, which told him that the painting was worth 200 units, but he had just told Mr. Chairman that it was only worth 100. Mr. Chairman truly was beloved among the citizens…

Mr. Joe gladly accepted it! Not because he wanted to hold it but because it could easily trade it for money, with profit!

He accepted art as a medium of exchange not because he wanted to hold it, but because he could sell it for profit. The Central Bank, unlike a private institution, can operate with loss  after loss, so it could “afford” to be mislead.

Oh well, enough with this dumb story…

What just happened?

There was an excessive money demand that should had led to a deflationary rot (not so big..) unless the Central Bank created more money. But the central bank unwillingly did not increase the money supply. Nevertheless it increased the money velocity, as the art dealer decreased its money demand by 200 (which indirectly paid for the extra demand). But in the end, all was paid by a big loss in the Central Bank capital position…

So, what’s the fuss all about? Three points.

  1. Bastiat’s Broken Window Fallacy does not apply when we have an excessive demand for money and the destruction is directed to a (non-convertible money issuing) Central Bank
  2. A Central Bank is not profit oriented so it can afford to have a loss. Therefore in a way, its loss was an non-injecting money helicopter drop.
  3. When we have a general depression, an increase in velocity (as seen) will do the job as well as an increase in the supply of money (so stupid CB actions like this one or smart Government Deficits could do the trick)

Attention attention! I am not advocating acts of destruction against money issuing Institutions.

As Keynes said, we can bury a bunch of notes and make people look for them.

But aren’t there more productive ways to do it?


3 thoughts on “The Art of Central Banking

  1. “We have full reserve backing, therefore banks are not creators of money”. Pay attention to Phillip George:
    “We may mention in passing the implications of our calculations for a favourite Austrian recommendation: 100% reserves. Implementing the recommendation would have disastrous effects, because it would mean that the 12 months of savings contained in demand deposits would not be lent out.”


  2. It’s actually worse than that. All bank-held savings are frozen, lost to both consumption and investment as DFIs always create new money whenever they lend/invest with the non-bank public. This is the sole and unique source of both stagflation and secular strangulation


  3. Monetary policy objectives should be formulated in terms of desired rates-of-change, roc’s, in monetary flows, (volume X’s velocity), relative to roc’s in R-gDp. Roc’s in N-gDp (though “raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in N-gDp”), can serve as a proxy figure for roc’s in all transactions, P*T, in Professor Irving Fisher’s truistic: “equation of exchange”.
    And Alfred Marshall’s cash-balances approach (viz., a schedule of the amounts of money that will be offered at given levels of “P”), viz., where at times “K” is the reciprocal of Vt, or “K” has the dimension of a “storage period” and “bridges the gaps of transition periods” in Yale Professor Irving Fisher’s model. Roc’s in R-gDp have to be used, of course, as a policy standard.
    Neither financial transactions not “animal spirits” are random:
    American, Yale Professor Irving Fisher – 1920 2nd edition: “The Purchasing Power of Money”:
    “If the principles here advocated are correct, the purchasing power of money — or its reciprocal, the level of prices — depends exclusively on five definite factors:
    (1)the volume of money in circulation;
    (2) its velocity of circulation;
    (3) the volume of bank deposits subject to check;
    (4) its velocity; and
    (5) the volume of trade.
    “Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an “equation of exchange.”
    “In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an EXACT SCIENCE, capable of precise formulation, demonstration, and statistical verification.”
    — Michel de Nostredame


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