Few people complain about high interest rates or having trouble finding credit during periods of sustained growth. Wages rise, assets increase in value, and capital is abundant. The last time we heard all the fallacious arguments about inflation not being that bad and low interest rates being essential for growth was in the early 1990s, when central banks in North America were trying to hold down general price increases under the influence of monetarist ideas.
For a decade, the calls for easy money and cheap credit remained subdued. But now that the stock markets are falling and hard times seemingly are upon us again, guess what? The monetary cranks are back! It’s become impossible to read any financial news without someone or other calling for the Fed, the Bank of Canada, or other central banks to lower interest rates and rescue us from the coming downturn.
It isn’t just credit-starved investors on the verge of bankruptcy, either. Even serious commentators in business publications are affected by this craze. Every day some analyst in The Wall Street Journal deplores the effect of “deflationary pressure” on the economy.
But the reader will never find any data to support these assertions. In fact, numbers show that the stock of money and credit has been rising fast in the U.S. in the past couple of months, so what is meant by deflation cannot be a decrease in the money supply. No, what we are led to believe is that there is deflation because there is not enough monetary expansion to prevent the fall in asset prices and to allow the boom to continue. Any example of people or firms losing money is interpreted as a sign of deflationary pressure.
In the National Post, Canada’s most consistently pro-free-market daily, columnist Sherry Cooper suggested that “a healthy infusion of monetary easing is just what the financial doctor ordered.” Michael Walker, executive director of the libertarian Fraser Institute in Vancouver, wrote in the same editorial page that “The Fed is now pumping money into the U.S. economy at a fantastic rate” and that the Bank of Canada should match the Fed’s moves by lowering interest rates.
That’s the kind of prescription you would expect from some old Keynesian economist stuck in his 1960’s mind-set. Until stagflation set in in the 1970s, most people believed that governments and central banks could “fine-tune” the economy and thereby prevent the reappearance of cyclical downturns as in the past. What they got, in Britain especially where this policy was followed more consistently than everywhere else, was an even faster and more destructive “stop-go” cycle that pushed the country deeper into the morass of inflation, balance of payments crisis and low growth.
So why would sophisticated free-market types, who should understand that the best policy is a stable supply of money, want us to return to this failed model? Why is everybody, including those who habitually oppose government intervention in the economy, clamoring for cuts in interest rates and expecting Greenspan and Dodge to perform miracles just by manipulating some financial levers?
Keynesianism/Monetarism
The reason may be that, on many points, there isn’t that much difference between Keynesianism and Monetarism. Although Monetarism was popularized by Milton Friedman and is generally identified with the rest of his work as part of libertarian economics, it is far from being a consistently free-market doctrine. Monetarists don’t believe money should be anchored in a commodity like gold or silver, and they see no problem in having a government-controlled fiat currency. They don’t oppose artificially inflating the money supply; instead, they advocate doing it slowly and at a steady rate in order to avoid rising prices. Also, although they understand that an unwarranted increase in the supply of money and credit will generate inflation and create an artificial boom, they don’t really have any explanation for the appearance of recession except that it must be caused by its opposite, that is, deflation or a shrinking money stock.
The result is that the same people who supported the fight against inflation ten years ago today call for an inflationary policy to stop the downward trend. In the case of Japan, for example, whose economy is still in the doldrums more than a decade after the bursting of a financial bubble, the same voices— from Friedman himself to The Economist magazine—have been calling for a “massive increase” in the quantity of money in order to kick-start growth. This, despite the fact the Bank of Japan has kept overnight interest rates at less than 0.5 percent for more than five years, and that one “emergency spending package” after another—a practice, it should be said in fairness, of which the monetarists disapprove—has been unveiled, causing the country’s debt to balloon and become the largest in the industrial world. If monetary stimulus could revive growth, it would no doubt have done so long ago in Japan.
Another one of these packages was unveiled recently after interest rates were lowered again. And this week, the Bank of Japan announced it was dropping interest rates as a target of policy and would instead try to boost the money supply more directly by increasing commercial banks’ reserves and buying more government debt. Banks loaded with bad loans and corporations unwilling to liquidate unprofitable units and unrealistic investments will get yet another infusion of funny money. Scarce capital that should go to more productive use will continue to remain idle or stuck in unproductive enterprises. For now, the monetary and fiscal boost again will have spared the country from falling into a deep recession, but it also will have prevented the restructuring that is necessary to put its economy back on its feet.
Still, those who share in the Keynesian-Monetarist consensus have only one solution for what they identify as “underconsumption” or “deflationary pressure”: inflate even more. Only one school of thought, the Austrian School of economics, has another interpretation.
The World According to Mises
The theory of the business cycle was developed by Ludwig von Mises in the early decades of the twentieth century. It shows that the boost created by cheap credit and an artificial lowering of interest rates—which we have been experiencing in North America since the mid-1990s—inevitably will lead to a bust, no matter what the central bank does. Stated in a very simplified manner, the reasoning is that many of the expansion projects that business was tempted to embark upon when credit was cheap turn out to be unsustainable when distorted production costs go up during the boom and profits end up lower than expected. These projects can only be sustained through ever larger quantities of easy money and artificially low interest rates. But if the central bank, for fear of igniting an inflationary spiral, puts a brake on credit creation, they will be revealed as malinvestments and will have to be liquidated.
Further monetary easing can only delay the necessary adjustments, create more malinvestments, and prolong the period of stagnation. This is what is happening in Japan. Pundits don’t seem to realize this, however, and they unanimously believe that the only way out is through more of the same. Sherry Cooper compares loosening the monetary policy to “a flu shot—it cannot hurt, and it could certainly help.” In fact, it resembles more an additional dose of hard drugs that you would administer to an addict who suffers from withdrawal symptoms so as to alleviate his pain. The symptoms are not the sickness. Although they make the patient very uncomfortable, they are a necessary phase if he is ever to recover.
In the same way, it is wrong to want to prevent the liquidation of malinvestments, even if nobody enjoys having to suffer or witness painful corporate restructuring and temporarily higher unemployment. Easy money caused the problem, so it cannot be its solution. Letting the downturn run its course is the only way to liberate the unproductive labor and capital resources and replenish the pool of real savings that will serve to launch a new and sustained growth phase.
Even leaving aside the question of malinvestments and how to engineer a quick recovery, it is deplorable to see professed libertarians and supporters of the free market advocate inflationary policies. People who understand the logic of free markets know that it is totally counterproductive for the government to bail out declining or failing industries. The taxes that are levied to finance the subsidies kill jobs and businesses elsewhere, and the subsidies themselves usually end up only delaying the inevitable closure of the decaying plants and white elephants. Inflation is no different and should be condemned in the same way. It is an invisible tax on creditors and money holders, and it redistributes resources to debtors and those who unwisely made investments they should not have made. Central banks have no business bailing them out by having all of us bear the brunt of it.
One could argue that there is no justice in this, in the sense that those who made the decisions to invest could not know that they were being deceived by central bank manipulations. The businessmen who thought capital had become more abundant and invested in new machinery were misled. The middle-class families or the pensioners who invested their savings in the stock market boom were misled.
But that does not justify attacking the property of others so that they won’t suffer as much for having been naive. Immorality is a defining feature of all interventionist policies, and we will have to bear with it as long as money stays in the hands of government instead of being a freely produced commodity.
