The title of my paper is the following question. In the face of changes in the demand for money,
what is the proper response by the central bank? Departing from that question, today
we'll try to conclude about the convenience of a monetary regime with the state monopoly
of the money supply, forced legal tender and central bank versus the alternative of competitive
with Money Supply. It will be assumed in this presentation that, like any other economic
good, money is subject to the laws of supply and demand, that money is an economic good
that derives its utility from its use as a medium of exchange, that the aggregated amount
of money that each economic agent chooses to keep as cash balance is the demand for
for Money, and that the supply of money may be institutionally framed to be provided either
competitively by the market or monopolistically by the state.
Why keep cash balances? Since the utility provided by money is a consequence of its
attribute of being generally accepted in exchanges, it is in this store potential to have ready
Many factors influence the cash balances economic agents choose to keep. Uncertainty regards
the future amount of usual transactions which is correlated to their income, extent that
the aggregate cash flows of economic agents match. Transactions, costs of financial investments
and Short-Term Interest Rates.
The main problems originated by variations
in the supply and demand for money
are the result of changes in the purchasing power
and the misallocations caused by the non-neutral
characteristic of such variations.
Economic crisis are nothing more than periods of time
required for the corrections of the misallocations
is provoked by the inflationary expansions of the money supply to complete their course.
Please note that economic crisis increases uncertainty and uncertainty about the future
is a key element to increase the demand for money.
Nice bank note, don't you think?
So, if the money supply is a government monopoly, what should be the government's proper response
in case of an increased demand for money in an economic crisis? Is it proper to increase
again the money supply in order to match the increased demand, or it is proper response
to do justice and let the sky fall.
If the government keeps the supply of money constant
in face of an increased demand for money,
it will force asset liquidations beyond the misallocations
that need to be corrected,
producing even bigger economic contractions.
If the government supplies extra money,
It will result in other plethora of bad things. It will generate an excess supply of money as soon as confidence is restored. Given the non-neutral characteristic of money, it will result in other misallocations, and it may generate all sorts of privileges, moral hazards, and increase in the size of the state sector. Having said all that, it is my opinion that under the institutional framework of fiat money,
Standard and Central Bank, the proper action for the government to take is to attend the demand,
the increased demand for money, increasing the money supply, being such course of action justified as the lesser evil.
However, this course of action has terrible consequences, as mentioned before.
Therefore, if under the current monetary arrangements in place almost everywhere,
and everywhere. The best thing that can be done is a bad thing. A case may be made that
the entire institutional edifice of state-controlled monopoly of the money supply is a flawed one
and a new monetary constitution must be thought out.
Let's start our analysis about the demand for money by the neoclassical models. Neoclassical
The economists consider money like any other good as subject to the market forces, supply
and demand for money, therefore may be expressed in the classical forms of curves of supply
and demand.
The use of this model to the case of money is particularly important because the demand
for money is strongly influenced by some variables that governments aim to control manipulating
the money supply.
There are subjective factors implicit in the neoclassical analysis, though. Quoting Ladler,
theories of the demand for money are not logically incompatible with the notion that the demand
for money, in fact, arises from its usefulness in making transactions or with a proposition
that is an excellent hedge against the risks inherent in holding assets. And he concludes,
all theories of the demand for money rest in considerations having to do with uncertainty
and the Passage of Time.
This is, I don't need to force this on you.
Having said that, as you all know,
the demand for money in the neoclassical paradigm
is presented as a simple alternative
between holding cash or bonds
and therefore as a function of the rate of interest
at any given level.
Concluding this neoclassical digression, it is important to say that the quantitative theory of money is just an application of the general theory of supply and demand for the case of money, and as stated by Mises, its main flaw is to assume that money is neutral and not to state that there is a causal relation between prices and the quantity of money.
This is not the place to discuss the many methodological and conceptual differences between the neoclassical consensus and Austrian economics, but to stress that from a shared understanding of the essential role of money in society, of its main features and its endogenous determination of value, neoclassical and Austrian economists alike can accept that subjective evaluations about uncertainty are key in determining the demand for money.
Now, is any amount of money as good as any other? When arguing that it would be a waste of social resources to add to any existing quantity of money, Mises wrote that the services which money renders can be neither improved nor repaired by changing the supply of money.
But this statement admits a qualification, however. Professors Barnett and Block assume that it is obvious from Mises and Rothbard's statements that both are referring to a commodity money.
In praxeology, the demand for money is the aggregation of the individual preferences
for cash balances. The optimum amount of money is a consequence of sum of individual preferences.
In the framework of competitive provided commodity money, these preferences may be accommodated
by an increase or decrease respectively in the supply of money, the preferences for cash
or by a change in the purchasing power of the commodity money.
Quoting again, Professors Barnett and Block,
the optimum quantity of money is not then whatever quantity happens to exist,
but rather whatever amount of gold as coins the free market process creates.
If this interpretation is correct, then it may be accepted from an Austrian standpoint
that it's not any existing quantity of money in use by society at a given moment that performs
the services desired by the economic agents. Fluctuations in the supply and demand for
money should accommodate the sum of personal preferences, like the functions of demand
and supply of any other good. And like what happens with any other good, these preferences
May Vary.
As we saw, the postulate of any amount of money is as good as any other, does not work
in the specific case of commodity money.
If such postulate is not valid for commodity money, what would be a general demand or function
for money from an Austrian perspective?
The aggregate of individual preferences determine how supply and demand for money are accommodated
regardless of the specific monetary regime enforced.
Violent changes in cash balances preference generate violent changes in price and quantities
traded plus or minus the variation in the money supply according to the rule established.
If so, from an Austrian perspective, what to do about the demand for money under monetary arrangements of fiat money in which the cost of creating money is marginally insignificant?
In the imperfect markets of mixed economy societies, rigidities and limitations are imposed on the free exchange of goods, services and labor.
Under these circumstances, a case may be made that when society is in the downturn of a business cycle, the cost of making any adjustment of supply and demand of goods and services by deflation is relatively more expensive than allowing the adjustment to happen, keeping the purchase power of money constant.
It is undisputed that in face of an increased demand for money, a non-flexible money supply will force prices down.
This phenomenon has a psychological origin. Economic agents have a sense of entitlement to the relative value of their goods and skills and reluctantly accept to be the first to take a loss to the current price of their property.
The pressure to lower prices in order to adjust an increased money preference to a constant money supply is expected to result in a decreased production.
Price stability in time of crisis can be achieved by increasing the supply of money to accommodate an increased demand for cash balances.
The analysis presented so far describes reality from a perspective that both neoclassical and Austrian economists can accept.
Is the current economic crisis an emergency case, such as an armed conflict? Do circumstances
in which the principles under which civil society are based are not applied because
of Civilty was replaced by a state of war? No. Therefore, the solution must be consistent
with the principles best suited for organizing a civil society. Nonetheless, the response
to the current crisis has been more interventionism. It's beyond doubt that commercial protectionism,
subsidies and protection for non-competitive industries or political favorites and increased
governmental expenditure are against the principles of limited government, and no aspect of the
reality justify departing from these poor principles.
But are the support given to banks and insurance companies by governmental loans financed by
Massive increases of the public debt and quantitative easing. Also not regrettable. Yes, they are regrettable. But here, the answer may be in once.
For good or evil, the law of the land in the US has been a state monopoly of the money supply, legal force standard, fractional reserve banking and central bank since 1913.
The monetary constitution of the US is not what it was at the founding, and the creation of the Fed in 1913 was a major departure.
Other changes since then only can substantiate the trend towards fiat money initiated in 1913 and completed in 1972.
At this time it seems relevant to mention the position of Austrian economists in regards to a secondary depression.
Expansion. It's clear that the measures to avoid the secondary depression are the ones
required to eliminate the rigidities and inefficiencies in the economy and not to produce further
credit expansion. But the relevant question for our analysis is what to do if it appears
politically impossible to take the necessary measures. Professor Huerta de Soto reminds
So, Austrian economists do accept that cases of special circumstances which may require
where nuanced responses can happen.
And the final part of this presentation
frames this response in a principal way,
appealing to prudence,
seen in this picture playing with a snake
while admiring herself in a mirror,
something that's not exactly prudent.
Prudence is used here in a modern New Aristotelian definition.
Prudence is intelligent management of the components needed for living a good life, a good human life.
Some of the components are given by nature, others by our environment,
and still others are fashioned by the logic of our own choices and it is in this sense as the way to achieve a good life that an appeal to an intelligent management of the circumstances on the ground as shown here by Aristotle in the picture that prudence may be understood as a principle of action in the context of our discussion.
In the regime of state monopoly, fiat money, central bank and fractional banking, the central bank has the obligation to act as a lender of last resort for the financial system.
It is a legal obligation, more than that, it's a logically necessary consequence of the existing financial structure.
What needs to be made clear in relation to the post-crisis monetary expansion promoted by central banks around the globe is that it is an integral part of the financial system as it is structured.
If most of lending is now done outside regular commercial banks, it's only to be expected
that the central banks will provide liquidity for financial transactions outside the regular
banking system as well.
In the same way, it's not part of this inquiry to analyze the correctness of the different
actions taken by central banks in general or the Fed in particular.
However, the perception that privileges and moral hazards are a necessary consequence of the process must be awaited in any evaluation of the current system.
Now my conclusions.
First, in providing liquidity the central bank is honoring its legal and logical obligations as lender of last resort for the financial system as it is currently organized.
and that is no more an evil than any other essential feature
of the current monetary constitution.
It's not an optional feature of the system
and cannot be evaluated apart from the rest.
Second, if understood that an increase in the money supply
is something wrong per se,
still it must be evaluated in the context
of the entire financial edifice
of which it is an essential feature.
Finally, if providing liquidity is a source
of Further Misallocations, Inefficiencies, Privileges,
and Moral Hazard.
If understood as an unpardonable flaw,
it means a condemnation of the entire edifice.
If fractional banking cannot subsist
without a lender of less resort,
and this less resort lender has no other way
to fund its operations than by the printing machine,
it must be understood as a condemnation
of fractional reserve banking
and not of less resort lending.