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.
- 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
- 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.
- 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?