WEBVTT NOTE What is the Proper Response by the Central Bank to Changes in the Demand for Money? 1 00:00:00.000 --> 00:00:07.760 The title of my paper is the following question. In the face of changes in the demand for money, 2 00:00:07.760 --> 00:00:13.440 what is the proper response by the central bank? Departing from that question, today 3 00:00:13.440 --> 00:00:18.240 we'll try to conclude about the convenience of a monetary regime with the state monopoly 4 00:00:18.240 --> 00:00:23.920 of the money supply, forced legal tender and central bank versus the alternative of competitive 5 00:00:23.920 --> 00:00:34.560 with Money Supply. It will be assumed in this presentation that, like any other economic 6 00:00:34.560 --> 00:00:40.260 good, money is subject to the laws of supply and demand, that money is an economic good 7 00:00:40.260 --> 00:00:46.100 that derives its utility from its use as a medium of exchange, that the aggregated amount 8 00:00:46.100 --> 00:00:51.260 of money that each economic agent chooses to keep as cash balance is the demand for 9 00:00:51.260 --> 00:00:57.300 for Money, and that the supply of money may be institutionally framed to be provided either 10 00:00:57.300 --> 00:01:05.340 competitively by the market or monopolistically by the state. 11 00:01:05.340 --> 00:01:11.780 Why keep cash balances? Since the utility provided by money is a consequence of its 12 00:01:11.780 --> 00:01:19.020 attribute of being generally accepted in exchanges, it is in this store potential to have ready 13 00:01:19.020 --> 00:01:33.740 Many factors influence the cash balances economic agents choose to keep. Uncertainty regards 14 00:01:33.740 --> 00:01:40.060 the future amount of usual transactions which is correlated to their income, extent that 15 00:01:40.060 --> 00:01:48.660 the aggregate cash flows of economic agents match. Transactions, costs of financial investments 16 00:01:48.660 --> 00:01:51.540 and Short-Term Interest Rates. 17 00:01:54.800 --> 00:01:57.740 The main problems originated by variations 18 00:01:57.740 --> 00:01:59.720 in the supply and demand for money 19 00:01:59.720 --> 00:02:03.900 are the result of changes in the purchasing power 20 00:02:03.900 --> 00:02:06.820 and the misallocations caused by the non-neutral 21 00:02:06.820 --> 00:02:09.700 characteristic of such variations. 22 00:02:09.700 --> 00:02:13.380 Economic crisis are nothing more than periods of time 23 00:02:13.380 --> 00:02:16.260 required for the corrections of the misallocations 24 00:02:16.260 --> 00:02:21.460 is provoked by the inflationary expansions of the money supply to complete their course. 25 00:02:21.460 --> 00:02:28.220 Please note that economic crisis increases uncertainty and uncertainty about the future 26 00:02:28.220 --> 00:02:37.060 is a key element to increase the demand for money. 27 00:02:37.060 --> 00:02:40.340 Nice bank note, don't you think? 28 00:02:40.340 --> 00:02:48.260 So, if the money supply is a government monopoly, what should be the government's proper response 29 00:02:48.260 --> 00:02:54.820 in case of an increased demand for money in an economic crisis? Is it proper to increase 30 00:02:54.820 --> 00:03:01.980 again the money supply in order to match the increased demand, or it is proper response 31 00:03:01.980 --> 00:03:05.300 to do justice and let the sky fall. 32 00:03:13.020 --> 00:03:15.940 If the government keeps the supply of money constant 33 00:03:15.940 --> 00:03:18.660 in face of an increased demand for money, 34 00:03:18.660 --> 00:03:23.020 it will force asset liquidations beyond the misallocations 35 00:03:23.020 --> 00:03:24.880 that need to be corrected, 36 00:03:24.880 --> 00:03:27.740 producing even bigger economic contractions. 37 00:03:28.620 --> 00:03:30.740 If the government supplies extra money, 38 00:03:30.740 --> 00:04:00.740 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, 39 00:04:00.740 --> 00:04:06.740 Standard and Central Bank, the proper action for the government to take is to attend the demand, 40 00:04:06.740 --> 00:04:14.740 the increased demand for money, increasing the money supply, being such course of action justified as the lesser evil. 41 00:04:17.740 --> 00:04:25.740 However, this course of action has terrible consequences, as mentioned before. 42 00:04:25.740 --> 00:04:29.740 Therefore, if under the current monetary arrangements in place almost everywhere, 43 00:04:29.740 --> 00:04:34.460 and everywhere. The best thing that can be done is a bad thing. A case may be made that 44 00:04:34.460 --> 00:04:41.460 the entire institutional edifice of state-controlled monopoly of the money supply is a flawed one 45 00:04:41.460 --> 00:04:49.460 and a new monetary constitution must be thought out. 46 00:04:49.460 --> 00:04:55.060 Let's start our analysis about the demand for money by the neoclassical models. Neoclassical 47 00:04:55.060 --> 00:05:00.740 The economists consider money like any other good as subject to the market forces, supply 48 00:05:00.740 --> 00:05:06.220 and demand for money, therefore may be expressed in the classical forms of curves of supply 49 00:05:06.220 --> 00:05:10.060 and demand. 50 00:05:10.060 --> 00:05:15.380 The use of this model to the case of money is particularly important because the demand 51 00:05:15.380 --> 00:05:21.020 for money is strongly influenced by some variables that governments aim to control manipulating 52 00:05:21.020 --> 00:05:23.380 the money supply. 53 00:05:23.380 --> 00:05:28.940 There are subjective factors implicit in the neoclassical analysis, though. Quoting Ladler, 54 00:05:28.940 --> 00:05:34.420 theories of the demand for money are not logically incompatible with the notion that the demand 55 00:05:34.420 --> 00:05:40.220 for money, in fact, arises from its usefulness in making transactions or with a proposition 56 00:05:40.220 --> 00:05:46.540 that is an excellent hedge against the risks inherent in holding assets. And he concludes, 57 00:05:46.540 --> 00:05:51.620 all theories of the demand for money rest in considerations having to do with uncertainty 58 00:05:51.620 --> 00:05:53.400 and the Passage of Time. 59 00:05:56.860 --> 00:06:01.420 This is, I don't need to force this on you. 60 00:06:02.460 --> 00:06:06.140 Having said that, as you all know, 61 00:06:06.140 --> 00:06:08.740 the demand for money in the neoclassical paradigm 62 00:06:08.740 --> 00:06:10.780 is presented as a simple alternative 63 00:06:10.780 --> 00:06:12.620 between holding cash or bonds 64 00:06:12.620 --> 00:06:15.180 and therefore as a function of the rate of interest 65 00:06:15.180 --> 00:06:17.280 at any given level. 66 00:06:17.280 --> 00:06:40.280 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. 67 00:06:40.280 --> 00:07:10.280 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. 68 00:07:10.280 --> 00:07:31.280 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. 69 00:07:31.280 --> 00:07:47.280 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. 70 00:07:47.280 --> 00:07:56.880 In praxeology, the demand for money is the aggregation of the individual preferences 71 00:07:56.880 --> 00:08:03.560 for cash balances. The optimum amount of money is a consequence of sum of individual preferences. 72 00:08:03.560 --> 00:08:09.760 In the framework of competitive provided commodity money, these preferences may be accommodated 73 00:08:09.760 --> 00:08:15.680 by an increase or decrease respectively in the supply of money, the preferences for cash 74 00:08:15.680 --> 00:08:20.680 or by a change in the purchasing power of the commodity money. 75 00:08:20.680 --> 00:08:23.680 Quoting again, Professors Barnett and Block, 76 00:08:23.680 --> 00:08:29.680 the optimum quantity of money is not then whatever quantity happens to exist, 77 00:08:29.680 --> 00:08:38.680 but rather whatever amount of gold as coins the free market process creates. 78 00:08:38.680 --> 00:08:44.680 If this interpretation is correct, then it may be accepted from an Austrian standpoint 79 00:08:44.680 --> 00:08:51.760 that it's not any existing quantity of money in use by society at a given moment that performs 80 00:08:51.760 --> 00:08:57.360 the services desired by the economic agents. Fluctuations in the supply and demand for 81 00:08:57.360 --> 00:09:02.760 money should accommodate the sum of personal preferences, like the functions of demand 82 00:09:02.760 --> 00:09:08.200 and supply of any other good. And like what happens with any other good, these preferences 83 00:09:08.200 --> 00:09:13.880 May Vary. 84 00:09:13.880 --> 00:09:19.440 As we saw, the postulate of any amount of money is as good as any other, does not work 85 00:09:19.440 --> 00:09:22.360 in the specific case of commodity money. 86 00:09:22.360 --> 00:09:29.680 If such postulate is not valid for commodity money, what would be a general demand or function 87 00:09:29.680 --> 00:09:34.280 for money from an Austrian perspective? 88 00:09:34.280 --> 00:09:39.760 The aggregate of individual preferences determine how supply and demand for money are accommodated 89 00:09:39.760 --> 00:09:44.440 regardless of the specific monetary regime enforced. 90 00:09:44.440 --> 00:09:50.040 Violent changes in cash balances preference generate violent changes in price and quantities 91 00:09:50.040 --> 00:09:59.040 traded plus or minus the variation in the money supply according to the rule established. 92 00:09:59.040 --> 00:10:12.040 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? 93 00:10:12.040 --> 00:10:22.040 In the imperfect markets of mixed economy societies, rigidities and limitations are imposed on the free exchange of goods, services and labor. 94 00:10:22.040 --> 00:10:42.040 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. 95 00:10:42.040 --> 00:10:52.040 It is undisputed that in face of an increased demand for money, a non-flexible money supply will force prices down. 96 00:10:52.040 --> 00:11:10.040 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. 97 00:11:10.040 --> 00:11:19.040 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. 98 00:11:19.040 --> 00:11:28.040 Price stability in time of crisis can be achieved by increasing the supply of money to accommodate an increased demand for cash balances. 99 00:11:28.040 --> 00:11:36.040 The analysis presented so far describes reality from a perspective that both neoclassical and Austrian economists can accept. 100 00:11:36.040 --> 00:11:57.940 Is the current economic crisis an emergency case, such as an armed conflict? Do circumstances 101 00:11:57.940 --> 00:12:04.320 in which the principles under which civil society are based are not applied because 102 00:12:04.320 --> 00:12:12.800 of Civilty was replaced by a state of war? No. Therefore, the solution must be consistent 103 00:12:12.800 --> 00:12:23.440 with the principles best suited for organizing a civil society. Nonetheless, the response 104 00:12:23.440 --> 00:12:31.600 to the current crisis has been more interventionism. It's beyond doubt that commercial protectionism, 105 00:12:31.600 --> 00:12:38.720 subsidies and protection for non-competitive industries or political favorites and increased 106 00:12:38.720 --> 00:12:46.280 governmental expenditure are against the principles of limited government, and no aspect of the 107 00:12:46.280 --> 00:12:51.120 reality justify departing from these poor principles. 108 00:12:51.120 --> 00:12:58.060 But are the support given to banks and insurance companies by governmental loans financed by 109 00:12:58.060 --> 00:13:12.060 Massive increases of the public debt and quantitative easing. Also not regrettable. Yes, they are regrettable. But here, the answer may be in once. 110 00:13:12.060 --> 00:13:30.060 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. 111 00:13:30.060 --> 00:13:40.060 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. 112 00:13:40.060 --> 00:13:57.060 Other changes since then only can substantiate the trend towards fiat money initiated in 1913 and completed in 1972. 113 00:13:57.060 --> 00:14:08.060 At this time it seems relevant to mention the position of Austrian economists in regards to a secondary depression. 114 00:14:08.060 --> 00:14:13.580 Expansion. It's clear that the measures to avoid the secondary depression are the ones 115 00:14:13.580 --> 00:14:19.580 required to eliminate the rigidities and inefficiencies in the economy and not to produce further 116 00:14:19.580 --> 00:14:27.820 credit expansion. But the relevant question for our analysis is what to do if it appears 117 00:14:27.820 --> 00:14:34.140 politically impossible to take the necessary measures. Professor Huerta de Soto reminds 118 00:14:34.140 --> 00:15:01.620 So, Austrian economists do accept that cases of special circumstances which may require 119 00:15:01.620 --> 00:15:04.340 where nuanced responses can happen. 120 00:15:04.340 --> 00:15:06.100 And the final part of this presentation 121 00:15:06.100 --> 00:15:09.160 frames this response in a principal way, 122 00:15:09.160 --> 00:15:10.940 appealing to prudence, 123 00:15:10.940 --> 00:15:15.820 seen in this picture playing with a snake 124 00:15:15.820 --> 00:15:18.940 while admiring herself in a mirror, 125 00:15:18.940 --> 00:15:22.180 something that's not exactly prudent. 126 00:15:22.180 --> 00:15:33.180 Prudence is used here in a modern New Aristotelian definition. 127 00:15:33.180 --> 00:15:41.180 Prudence is intelligent management of the components needed for living a good life, a good human life. 128 00:15:41.180 --> 00:15:46.180 Some of the components are given by nature, others by our environment, 129 00:15:46.180 --> 00:16:13.380 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. 130 00:16:16.180 --> 00:16:31.180 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. 131 00:16:31.180 --> 00:16:39.180 It is a legal obligation, more than that, it's a logically necessary consequence of the existing financial structure. 132 00:16:39.180 --> 00:16:54.180 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. 133 00:16:54.180 --> 00:17:00.980 If most of lending is now done outside regular commercial banks, it's only to be expected 134 00:17:00.980 --> 00:17:06.940 that the central banks will provide liquidity for financial transactions outside the regular 135 00:17:06.940 --> 00:17:11.220 banking system as well. 136 00:17:11.220 --> 00:17:16.420 In the same way, it's not part of this inquiry to analyze the correctness of the different 137 00:17:16.420 --> 00:17:21.460 actions taken by central banks in general or the Fed in particular. 138 00:17:21.460 --> 00:17:34.460 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. 139 00:17:34.460 --> 00:17:37.460 Now my conclusions. 140 00:17:37.460 --> 00:17:50.460 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. 141 00:17:50.460 --> 00:17:54.860 and that is no more an evil than any other essential feature 142 00:17:54.860 --> 00:17:57.540 of the current monetary constitution. 143 00:17:57.540 --> 00:18:00.240 It's not an optional feature of the system 144 00:18:00.240 --> 00:18:04.100 and cannot be evaluated apart from the rest. 145 00:18:04.100 --> 00:18:07.940 Second, if understood that an increase in the money supply 146 00:18:07.940 --> 00:18:09.860 is something wrong per se, 147 00:18:09.860 --> 00:18:12.340 still it must be evaluated in the context 148 00:18:12.340 --> 00:18:14.180 of the entire financial edifice 149 00:18:14.180 --> 00:18:16.900 of which it is an essential feature. 150 00:18:16.900 --> 00:18:19.940 Finally, if providing liquidity is a source 151 00:18:19.940 --> 00:18:23.620 of Further Misallocations, Inefficiencies, Privileges, 152 00:18:23.620 --> 00:18:25.140 and Moral Hazard. 153 00:18:25.140 --> 00:18:28.920 If understood as an unpardonable flaw, 154 00:18:28.920 --> 00:18:32.380 it means a condemnation of the entire edifice. 155 00:18:32.380 --> 00:18:34.780 If fractional banking cannot subsist 156 00:18:34.780 --> 00:18:36.800 without a lender of less resort, 157 00:18:36.800 --> 00:18:39.100 and this less resort lender has no other way 158 00:18:39.100 --> 00:18:43.260 to fund its operations than by the printing machine, 159 00:18:43.260 --> 00:18:45.640 it must be understood as a condemnation 160 00:18:45.640 --> 00:18:47.380 of fractional reserve banking 161 00:18:47.380 --> 00:18:49.620 and not of less resort lending.