March 21, 2016

Money, Liquidity and the Gold Standard, Part 2

As I explained in the first part of this article, the theory of money is an essential part of macroeconomics. Just like economic theory in general, monetary theory provides a systemic understanding of:
  • how the economy works; and
  • the consequences of economic policy.
Without a systemic understanding, solidly founded in economic theory, our policy recommendations will sooner or later fail. History is filled to the brim with ill-founded fiscal and monetary policy endeavors that have hit the proverbial iceberg because its navigators had not studied the map well enough. In some instances these failures have caused major problems for the economy where the policies were applied.
While this is not the place to discuss those failures in depth, three that come to mind are the welfare state (as a system of economic and social policy initiatives), the European monetary union and, on a smaller scale, the Obama administration's so called "stimulus bill" of 2009.

In the field of monetary economics there is an ongoing controversy over what policies a central bank should follow: to make it simple, the choice is between accommodating to the swings in the business cycle, or strictly monetarist. The Federal Reserve has traditionally been more accommodating than European central banks, while the European Central Bank, e.g., was founded on a constitution that prescribed strict adherence to monetarism.

Judging from the general difference in macreconomic performance between the U.S. economy and the euro zone - and assuming all other things equal - accommodating monetary policy is the way to go. That is a general observation, not an endorsement or criticism of Quantitative Easing. That particular episode in U.S. monetary policy history deserves an article of its own. The reason is that the motives behind QE were different from the motives behind historic, accommodating monetary policy in the United States. QE was motivated by budget deficits; monetary accommodation is motivated by swings in the business cycle.

The practical meaning of monetary accommodation is that the central bank expands money supply in recessions while stabilizing it in growth periods. As a result, interest rates are low in recessions, motivating consumers to maintain some credit-driven consumption and businesses to keep some level of investment going. Low interest rates also facilitate an economic recovery when the private sector is ready for it.

This observation - easily verifiable by an ample supply of macroeconomic data - is explainable by the theoretical discussion in the first part of this article. There, I explained that money has two functions in the economy, namely as a means of carrying value and as the "anchor" of liquidity. The first function is embraced by all theories of money, and is approximately represented in traditional macroeconomics textbooks as the "transactions demand for money".

The second function is straight out of Keynesian theory, and is linked directly to one of its key elements, namely the presence of uncertainty in the economy. In times of uncertainty we prefer to hold as much of our assets as liquid as possible; we do not want to tie up our savings in some asset that takes a long time to liquidate. Therefore, when the future looks uncertain we increase demand for money just to keep our assets as "spendable" as possible.

Traditional monetary theory crudely represents this as the "speculative" form of monetary demand. The term misrepresents the liquidity preference, but that is a topic for a more eclectic conversation among devout Keynesians. The point here is that the economy is helped by the fact that there is ample supply of liquidity in times of uncertainty: by liquidating their assets consumers and entrepreneurs can concentrate on restoring confidence in the future.

Where does this supply of liquidity come from? The central bank. It is by printing more money in recessions that the central bank can help the private sector recover their confidence. But printing money in recessions is antithetical to both monetarism and Austrian theory:

  • According to monetarist theory, an expansion of the supply of money will inevitably lead to a proportionate increase in prices - i.e., inflation;
  • According to Austrian theory, the expansion of money supply in a recession "artificially" alters the intertemporal price of business investments, causing an excess expansion of capital today at the expense of tomorrow. 

The Austrian over-capitalization point is important in our understanding of why Austrian theory is not useful in the context of macroeconomic analysis, and especially not as a platform for fiscal or monetary policy decisions. More specifically, its recommendation would be to tighten money supply in recessions - yet that would only raise the price of liquidity, make it more difficult for households and businesses to manage uncertainty and thereby put the recovery farther into the future.

Herein lies an important piece of criticism of the monetary gold standard. As archaic as this ideas is, it has gained new followers during the Great Recession, to a point where even some presidential candidates have alluded to it.

The idea with the gold standard is to link money supply to the supply of gold held by the Federal Reserve. As was the case half a century ago, the Federal Reserve would guarantee that the amount of U.S. dollars in the world would not exceed a certain dollar-per-ounce ratio. This would lock in money supply and allow it to expand if and only if the Federal Reserve expanded its gold reserve.

To a monetarist or Austrian, this sounds perfectly reasonable. However, the "theory" of the gold standard quickly becomes a ball and chain around the ankle of the economy, and here is why:

1. The normal state of affairs is that the supply of gold is constant;
2. Yet the economy grows continually, as we become more productive, invent new products, make better investments, make more money and spend more;
3. A growing economy needs more money for transactions purposes, or for the carrying of value;
4. With money supply constant, locked by the supply of gold, demand for money will soon run away from supply, resulting in a drastic increase in the price of liquidity - the interest rate.

Austrians would call this a "natural" stabilization of economic activity, where more investors postpone projects until "tomorrow". But since there is no reason to believe there will ever be an expansion of the gold held by the Federal Reserve, the economy will stagnate over time and revolve around its static money supply.

In other words, the gold-standard is an impediment to growth. By getting in the way of economic growth, the gold standard therefore deprives us all of the opportunity to expand our prosperity. But so does any monetary theory - or, for that matter, general macroeconomic theory - that is built on the idea that money is a means of transaction and carrier of value, but not a form of liquidity.

As a libertarian I am continuously surprised by the complete unanimity among other libertarians to raise Austrian economics to the skies. It is entirely possible to be a libertarian and a Keynesian at the same time!

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