Posts Tagged 'Scott Sumner'

Bernanke’s Continuing Confusion about How Monetary Policy Works

TravisV recently posted a comment on this blog with a link to his comment on Scott Sumner’s blog flagging two apparently contradictory rationales for the Fed’s quantitative easing policy in chapter 19 of Ben Bernanke’s new book in which he demurely takes credit for saving Western Civilization. Here are the two quotes from Bernanke:

1              Our goal was to bring down longer-term interest rates, such as the rates on thirty-year mortgages and corporate bonds. If we could do that, we might stimulate spending—on housing and business capital investment, for example…..Similarly, when we bought longer-term Treasury securities, such as a note maturing in ten years, the yields on those securities tended to decline.

2              A new era of monetary policy activism had arrived, and our announcement had powerful effects. Between the day before the meeting and the end of the year, the Dow would rise more than 3,000 points—more than 40 percent—to 10,428. Longer-term interest rates fell on our announcement, with the yield on ten-year Treasury securities dropping from about 3 percent to about 2.5 percent in one day, a very large move. Over the summer, longer-term yields would reverse and rise to above 4 percent. We would see that increase as a sign of success. Higher yields suggested that investors were expecting both more growth and higher inflation, consistent with our goal of economic revival. Indeed, after four quarters of contraction, revised data would show that the economy would grow at a 1.3 percent rate in the third quarter and a 3.9 percent rate in the fourth.

Over my four years of blogging — especially the first two – I have written a number of posts pointing out that the Fed’s articulated rationale for its quantitative easing – the one expressed in quote number 1 above: that quantitative easing would reduce long-term interest rates and stimulate the economy by promoting investment – was largely irrelevant, because the magnitude of the effect would be far too small to have any noticeable macroeconomic effect.

In making this argument, Bernanke bought into one of the few propositions shared by both Keynes and the Austrians: that monetary policy is effective by operating on long-term interest rates, and that significant investments by business in plant and equipment are responsive to relatively small changes in long-term rates. Keynes, at any rate, had the good sense to realize that long-term investment in plant and equipment is not very responsive to changes in long-term interest rates – a view he had espoused in his Treatise on Money before emphasizing, in the General Theory, expectations about future prices and profitability as the key factor governing investment. Austrians, however, never gave up their theoretical preoccupation with the idea that the entire structural profile of a modern economy is dominated by small changes in the long-term rate of interest.

So for Bernanke’s theory of how QE would be effective to be internally consistent, he would have had to buy into a hyper-Austrian view of how the economy works, which he obviously doesn’t and never did. Sometimes internal inconsistency can be a sign that being misled by bad theory hasn’t overwhelmed a person’s good judgment. So I say even though he botched the theory, give Bernanke credit for his good judgment. Unfortunately, Bernanke’s confusion made it impossible for him to communicate a coherent story about how monetary policy, undermining, or at least compromising, his ability to build popular support for the policy.

Of course the problem was even deeper than expecting a marginal reduction in long-term interest rates to have any effect on the economy. The Fed’s refusal to budge from its two-percent inflation target, drastically limited the potential stimulus that monetary policy could provide.

I might add that I just noticed that I had already drawn attention to Bernanke’s inconsistent rationale for adopting QE in my paper “The Fisher Effect Under Deflationary Expectations” written before I started this blog, which both Scott Sumner and Paul Krugman plugged after I posted it on SSRN.

Here’s what I said in my paper (p. 18):

If so, the expressed rationale for the Fed’s quantitative easing policy (Bernanke 2010), namely to reduce long term interest rates, thereby stimulating spending on investment and consumption, reflects a misapprehension of the mechanism by which the policy would be most likely to operate, increasing expectations of both inflation and future profitability and, hence, of the cash flows derived from real assets, causing asset values to rise in step with both inflation expectations and real interest rates. Rather than a policy to reduce interest rates, quantitative easing appears to be a policy for increasing interest rates, though only as a consequence of increasing expected future prices and cash flows.

I wrote that almost five years ago, and it still seems pretty much on the mark.

Neo-Fisherism and All That

A few weeks ago Michael Woodford and his Columbia colleague Mariana Garcia-Schmidt made an initial response to the Neo-Fisherian argument advanced by, among others, John Cochrane and Stephen Williamson that a central bank can achieve its inflation target by pegging its interest-rate instrument at a rate such that if the expected inflation rate is the inflation rate targeted by the central bank, the Fisher equation would be satisfied. In other words, if the central bank wants 2% inflation, it should set the interest rate instrument under its control at the Fisherian real rate of interest (aka the natural rate) plus 2% expected inflation. So if the Fisherian real rate is 2%, the central bank should set its interest-rate instrument (Fed Funds rate) at 4%, because, in equilibrium – and, under rational expectations, that is the only policy-relevant solution of the model – inflation expectations must satisfy the Fisher equation.

The Neo-Fisherians believe that, by way of this insight, they have overturned at least two centuries of standard monetary theory, dating back at least to Henry Thornton, instructing the monetary authorities to raise interest rates to combat inflation and to reduce interest rates to counter deflation. According to the Neo-Fisherian Revolution, this was all wrong: the way to reduce inflation is for the monetary authority to reduce the setting on its interest-rate instrument and the way to counter deflation is to raise the setting on the instrument. That is supposedly why the Fed, by reducing its Fed Funds target practically to zero, has locked us into a low-inflation environment.

Unwilling to junk more than 200 years of received doctrine on the basis, not of a behavioral relationship, but a reduced-form equilibrium condition containing no information about the direction of causality, few monetary economists and no policy makers have become devotees of the Neo-Fisherian Revolution. Nevertheless, the Neo-Fisherian argument has drawn enough attention to elicit a response from Michael Woodford, who is the go-to monetary theorist for monetary-policy makers. The Woodford-Garcia-Schmidt (hereinafter WGS) response (for now just a slide presentation) has already been discussed by Noah Smith, Nick Rowe, Scott Sumner, Brad DeLong, Roger Farmer and John Cochrane. Nick Rowe’s discussion, not surprisingly, is especially penetrating in distilling the WGS presentation into its intuitive essence.

Using Nick’s discussion as a starting point, I am going to offer some comments of my own on Neo-Fisherism and the WGS critique. Right off the bat, WGS concede that it is possible that by increasing the setting of its interest-rate instrument, a central bank could, move the economy from one rational-expectations equilibrium to another, the only difference between the two being that inflation in the second would differ from inflation in the first by an amount exactly equal to the difference in the corresponding settings of the interest-rate instrument. John Cochrane apparently feels pretty good about having extracted this concession from WGS, remarking

My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

And my first reaction to Cochrane’s first reaction is: why only half? What else is there to worry about besides a comparison of rational-expectations equilibria? Well, let Cochrane read Nick Rowe’s blogpost. If he did, he might realize that if you do no more than compare alternative steady-state equilibria, ignoring the path leading from one equilibrium to the other, you miss just about everything that makes macroeconomics worth studying (by the way I do realize the question-begging nature of that remark). Of course that won’t necessarily bother Cochrane, because, like other practitioners of modern macroeconomics, he has convinced himself that it is precisely by excluding everything but rational-expectations equilibria from consideration that modern macroeconomics has made what its practitioners like to think of as progress, and what its critics regard as the opposite .

But Nick Rowe actually takes the trouble to show what might happen if you try to specify the path by which you could get from rational-expectations equilibrium A with the interest-rate instrument of the central bank set at i to rational-expectations equilibrium B with the interest-rate instrument of the central bank set at i ­+ ε. If you try to specify a process of trial-and-error (tatonnement) that leads from A to B, you will almost certainly fail, your only chance being to get it right on your first try. And, as Nick further points out, the very notion of a tatonnement process leading from one equilibrium to another is a huge stretch, because, in the real world there are “no backs” as there are in tatonnement. If you enter into an exchange, you can’t nullify it, as is the case under tatonnement, just because the price you agreed on turns out not to have been an equilibrium price. For there to be a tatonnement path from the first equilibrium that converges on the second requires that monetary authority set its interest-rate instrument in the conventional, not the Neo-Fisherian, manner, using variations in the real interest rate as a lever by which to nudge the economy onto a path leading to a new equilibrium rather than away from it.

The very notion that you don’t have to worry about the path by which you get from one equilibrium to another is so bizarre that it would be merely laughable if it were not so dangerous. Kenneth Boulding used to tell a story about a physicist, a chemist and an economist stranded on a desert island with nothing to eat except a can of food, but nothing to open the can with. The physicist and the chemist tried to figure out a way to open the can, but the economist just said: “assume a can opener.” But I wonder if even Boulding could have imagined the disconnect from reality embodied in the Neo-Fisherian argument.

Having registered my disapproval of Neo-Fisherism, let me now reverse field and make some critical comments about the current state of non-Neo-Fisherian monetary theory, and what makes it vulnerable to off-the-wall ideas like Neo-Fisherism. The important fact to consider about the past two centuries of monetary theory that I referred to above is that for at least three-quarters of that time there was a basic default assumption that the value of money was ultimately governed by the value of some real commodity, usually either silver or gold (or even both). There could be temporary deviations between the value of money and the value of the monetary standard, but because there was a standard, the value of gold or silver provided a benchmark against which the value of money could always be reckoned. I am not saying that this was either a good way of thinking about the value of money or a bad way; I am just pointing out that this was metatheoretical background governing how people thought about money.

Even after the final collapse of the gold standard in the mid-1930s, there was a residue of metalism that remained, people still calculating values in terms of gold equivalents and the value of currency in terms of its gold price. Once the gold standard collapsed, it was inevitable that these inherited habits of thinking about money would eventually give way to new ways of thinking, and it took another 40 years or so, until the official way of thinking about the value of money finally eliminated any vestige of the gold mentality. In our age of enlightenment, no sane person any longer thinks about the value of money in terms of gold or silver equivalents.

But the problem for monetary theory is that, without a real-value equivalent to assign to money, the value of money in our macroeconomic models became theoretically indeterminate. If the value of money is theoretically indeterminate, so, too, is the rate of inflation. The value of money and the rate of inflation are simply, as Fischer Black understood, whatever people in the aggregate expect them to be. Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver. The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults. There was only an indirect connection – at least until the 1920s — between a central bank setting its interest-rate instrument to control its balance sheet and the effect on prices and inflation. The rules of monetary policy developed under a gold standard are not necessarily applicable to an economic system in which the value of money is fundamentally indeterminate.

Viewed from this perspective, the Neo-Fisherian Revolution appears as a kind of reductio ad absurdum of the present confused state of monetary theory in which the price level and the rate of inflation are entirely subjective and determined totally by expectations.

Why Theories of National Income Based on Accounting Identities Are Nonsensical and Error-Ridden, Part IV

In my previous post, I tried to relate the discussion of accounting identities to the familiar circular-flow diagram with injections into and leakages out of the flows of income, expenditure and output. My hopes that framing the discussion in terms of injections and leakages, with investment viewed as an injection into, and savings as a withdrawal out of, the flows of income and expenditure would help clarify my position about accounting identities were disappointed, as defenders of those accounting identities were highly critical of the injections-leakages analogy, launching a barrage of criticism at my argument that the basic macroeconomic model of income determination should not be understood in terms of the income-expenditure or the investment-savings identities.

I think that criticism of the injections-leakages analogy was, for the most part, misplaced and a based on a misunderstanding of what I have been aiming to do, but much of the criticism was prompted by my incomplete or inadequate explanation of my reasoning. So, before continuing with my summary of Lipsey’s essay on the subject, on which this series is based, I need to address at least some of the points that have been made by my (and Lipsey’s) various critics. In the course of doing so, I believe it will be helpful if I offer a revised version of Lipsey’s Table 1, which I reproduced in part III of this series.

First, I am not saying that the standard accounting identities are wrong. Definitions are neither right nor wrong, but they may be useful or not useful depending on the context. In everyday conversation, we routinely ascribe one of many possible meanings to particular words used by selecting one of the many possible definitions as that which is most likely to make an entire sequence of words – a phrase, a clause, or a sentence – meaningful. Our choice of which definition to use is generally determined by the context in which the word appears. Choosing one definition over another doesn’t mean that others are not valid, just that the others would not work as well or at all in the context in which the word in question appears. Working with an inappropriate definition in a given context can lead, as we all know from personal experience, to confusion, misunderstanding and error. Defining savings and investment to be equal in every state of the world is certainly possible, and doing so is not invalid, but doing so is not necessarily useful in the context of formulating a macroeconomic theory of income determination.

There are two reasons why defining savings and investment to be identically equal in all states of the world is not useful in a macroeconomic theory of income. First, if we define savings and investment (or income and expenditure) to be identically equal, we can’t solve, either algebraically or graphically, the system of equations describing the model for a unique equilibrium. According to the model, aggregate expenditure is assumed to be a function of income, but if income and expenditure are identical, expenditure is simply identical to itself, so the system of equations described by the model collapses onto the 45-degree line representing the expenditure-income identity.

Second, even if we interpret the equality of income and expenditure as an ex ante equilibrium condition, while asserting that identity between income and expenditure must always hold ex post, the ex post definitional equality tells us nothing about the adjustment process that restores equilibrium when, owing to some parameter change that disturbs a pre-existing equilibrium, the ex ante equilibrium condition does not hold. For a dynamic adjustment path to take the model from one equilibrium to another via a sequence of discrete adjustments, the model must incorporate some lags. Without lags, the adjustment would be instantaneous, and the model would move from its old equilibrium to a new equilibrium in one fell swoop. But in the course of a sequence of partial adjustments, savings and investment will typically have to be defined by the model so that they are not equal, and this will be reflected in the implied course of savings and investment if the model is worked out period-by-period. Or if you were to observe the Phillips machine (a hydraulic macroeconomic model built by A. W. Phillips of Phillips Curve fame) in action, you could actually see that the savings and investment flows were of unequal magnitudes as machine responded to a change in the settings and moved from one hydraulic equilibrium to another.

It is a common mistake, and the primary object of Richard Lipsey’s scorn in his essay, to attribute causal significance to the savings-investment identity, as if it were the force of the identity itself that guided the dynamic adjustment, when, in reality, the identity, which can always be recovered if one does all the necessary accounting and classifies all the transactions according to the accounting conventions, is irrelevant to the adjustment path. Doing the accounting does not explain how the model moves from the old to a new equilibrium; it just assures us that nothing has been omitted from a final description of what has happened. Rather, the causal mechanism driving the adjustment process can be described using the intuitive idea that income changes because there are injections (in the form of investment) into the income and expenditure flows and leakages (in the form of savings) out of those flows, and when the injections and leakages are unequal in magnitude, the discrepancy between the injections and the leakages causes a corresponding change in the income and expenditure flows.

One commenter pointed out that, even in the numerical example (taken from Lipsey’s essay) that I gave in my earlier post, the sequence of adjustments preserved the definitional equality between savings and investment and income and expenditure, even though the verbal explanation of the adjustment process showed that the equality of savings and investment required a rather forced interpretation of the meaning of savings: the difference between the cash balance expected at the end of a period and the actual cash balance at the end of the period. This peculiar interpretation of savings and its equality with investment reflected the way that Lipsey chose to introduce a lag between expenditure and income into the model: by assuming that income was disbursed by businesses to households at the end of the period in which households provide services to businesses. The income received at the end of one period is then used to finance consumption expenditures and savings in the following period.

I should have pointed out that if one made the trivial adjustment in the expenditure-income lag, so that incomes earned in one period are not at the end of the current period, but at the beginning of the following period, then income and expenditure and savings and investment would not remain equal over the course of the adjustment from the old to the new equilibrium. The sequence of adjustments under the alternative assumption is shown in Table 1 below.

Of course, if we assume that there is a one-period lag between expenditure and income, one could define something called total savings, which would be household savings plus business savings, where business savings is defined as the difference between cash held by businesses at the end of the current period and cash held by businesses at the end of the previous period. And total savings is identically equal to investment. However, it is important to bear in mind that from the point of view of the simple income-expenditure model, the relevant causal variable in determining equilibrium is not total savings, but household savings.

Why do I say that household savings, not business savings, is the relevant causal factor in determining equilibrium income in the simple income-expenditure model? The reason should be obvious: the solution for equilibrium in the simple income-expenditure model is Y = A/(1 – MPC), where A represents the autonomous component of consumption plus planned investment by business firms and MPC is the marginal propensity to consume by households, so that (1 – MPC) is the marginal propensity to save (MPS) . . . by households!

In this setup, business savings is a pure residual adjusting to make up the difference between household savings and investment. When household savings exceeds investment, businesses accumulate their holdings of cash, and when investment is greater than household saving, businesses reduce their accumulate cash. The operation of the banking system might be relevant at this point, but that analysis would take this discussion to a whole new level, which I am not going to get started on at this point.

I will close at this point by just saying that I think that I have provided an answer to the following comment on my previous post asking what is gained by introducing an alternative set of definitions of saving and investment under which savings and investment are equal only in equilibrium, but not otherwise:

But let’s just say you have a system of accounts where definitions are different and saving is different from investment. I can do a mathematical transformation to a new set of variables in which standard identities hold. What is the point of writing so much? Absolutely nothing.

The point of course is that by defining savings and investment so that they are equal only in equilibrium, we now have a system of two linear equations in two unknowns that can be solved for a unique solution, something that cannot be done if savings and investment are identically equal. Second, when we have defined savings and investment so that they can be unequal, but define their equality to be a condition of equilibrium, we can write the following dynamic relationships characterizing the system:

dY/dt = 0 <=> I = S

dY/dt > 0 <=> I > S

dY/dt < 0 <=> I < S

where I and S are defined under the behavioral assumptions in this example as actual investment by businesses and saving by households. The precise definition of I and S would depend, in each particular case, on the specific behavioral assumptions about the underlying lag structure of the model for that particular case. The definitional equality of total savings and investment has no causal significance, but simply reflects the fact that total savings is defined in such a way that it must equal investment.

The definitional equality of savings and investment, as Scott Sumner has observed, is exactly analogous to the quantity identity MV ≡ PY, when V is treated not as the reciprocal of the amount of money demanded as a fraction of income — which is to say as a measurable magnitude understood to be a function of specifiable independent variables — but simply as a residual whose value, by definition, must always be identically equal to PY/M. The quantity identity, lacking being consistent with all possible states of the world, because V is defined not as an independent variable, but as a mere residual. The quantity identity is therefore of no use in describing the dynamic process of adjustment to a change in the quantity of money or what in telling us what are the causes of such a process.

UPDATE (3/29/15): In writing a response to Jamie’s comment, I realized that in the third paragraph after the table above, I misstated the relationship between business savings and the difference between investment and household savings. I have made the correction, and apologize for not being more careful.

Imagination and Identity

Before continuing my summary of the key points of Richard Lipsey’s important paper, “The Foundations of the Theory of National Income,” I want to clear up a point that the deliberately provocative title may have obscured. The accounting identities that I am singling out for criticism are the identities between income and expenditure (and output) and between savings and investment. It is true that, as Scott Sumner points out in a comment on my previous post, every theory has to define its terms in some way or another, so there is no point in asserting that a definition is wrong. Scott believes that I am a saying that it is wrong to define investment and savings as the same thing, but I am not saying that. I am saying that, in the context of the basic income-expenditure theory of national income, it makes the theory incoherent, so that there is a mismatch between the definition and the theory.

It is also true that sometimes identities follow directly from basic definitions. Such identities are like conservation laws in physics. For example, purchases must equal sales, because purchasing and selling are reciprocal activities; to assert that purchases are, or could be, unequal to sales would be self-contradictory. Keynes, when ridiculed by Hawtrey for asserting that a) savings and investment are equal by definition, and b) that the equality of savings and investment is achieved by variations in income, responded by comparing the equality of savings and investment to the equality of purchases and sales. Purchases are necessarily equal to sales, but prices adjust to achieve equality between desired purchases and desired sales.

The problem with Keynes’s response to Hawtrey is that to assert that purchases are unequal to sales is to misconstrue in a really fundamental way the meaning of the terms “purchase” and “sales.” But when it comes to national-income accounting, the identity of “investment” and “savings” does not follow immediately from the meaning of those terms. It must be derived from the meaning of two other terms: income and expenditure. So the question becomes whether the act of spending (i.e., expenditure) necessarily entails an immediate and corresponding accrual of income, in the same way that the act of purchasing necessarily entails the act of selling. To assert that expenditure and income are identical is then to assert that any expenditure necessarily and simultaneously entails a corresponding accrual of income.

Before pursuing this line of thought further, let’s just pause for a moment to recall the context for this discussion. We are talking about a fairly primitive model of an economy in which there are households that are units of consumption and providers of factor services. Households purchase consumption goods and provide factor services to business firms. Business firms are units of production that combine factor services provided by households with raw materials purchased from other business firms, and new or existing capital goods produced now or previously by other business firms, to produce raw materials, consumption goods, and capital goods. Raw materials and capital goods are sold to other business firms and consumption goods are sold to households. Business firms are owned by households, so profits earned by business firms are remitted, along with payments for factor services, to households. But although the flow of payments from households to business firms corresponds to a flow of payments from business firms to households, the two flows, which can be measured separately, are, at not identical, or at least not obviously so. When I bought a tall Starbucks coffee just now at a Barnes & Noble cafe, my purchase of $1.98 was exactly and necessarily matched by a sale by Barnes & Noble to the guy who writes for the Uneasy Money blog. But expenditure of $1.98 by the Uneasy Money blogger to Barnes & Noble did not trigger an immediate and corresponding flow of $1.98 to households from Barnes & Noble.

Now I grant that it is possible for income so to be defined that every act of expenditure involves a corresponding accrual of income to providers of factor services to the firm, and of profit to owners of the firm. But expenditure entails simultaneous accrual of income only by virtue of an imputation of income to providers of factor services and of profit to owners of firms. Mere imputation does not and cannot constitute an actual flow of payments by firms to households. The identity between purchases and sales is entailed by the definition of “purchase” and “sales,’ but the supposed identity between expenditure and income is entailed by nothing but an act of imagination. I am not criticizing imagination, which may often provide us with an excellent grasp of reality. But imagination, no matter how well attuned to reality, does not and cannot establish identity.

Did David Hume Discover the Vertical Phillips Curve?

In my previous post about Nick Rowe and Milton Friedman, I pointed out to Nick Rowe that Friedman (and Phelps) did not discover the argument that the long-run Phillips Curve, defined so that every rate of inflation is correctly expected, is vertical. The argument I suggested can be traced back at least to Hume. My claim on Hume’s behalf was based on my vague recollection that Hume distinguished between the effect of a high price level and a rising price level, a high price level having no effect on output and employment, while a rising price level increases output and employment.

Scott Sumner offered the following comment, leaving it as an exercise for the reader to figure out what he meant by “didn’t quite get there.”:

As you know Friedman is one of the few areas where we disagree. Here I’ll just address one point, the expectations augmented Phillips Curve. Although I love Hume, he didn’t quite get there, although he did discuss the simple Phillips Curve.

I wrote the following response to Scott referring to the quote that I was thinking of without quoting it verbatim (because I couldn’t remember where to find it):

There is a wonderful quote by Hume about how low prices or high prices are irrelevant to total output, profits and employment, but that unexpected increases in prices are a stimulus to profits, output, and employment. I’ll look for it, and post it.

Nick Rowe then obligingly provided the quotation I was thinking of (but not all of it):

Here, to my mind, is the “money quote” (pun not originally intended) from David Hume’s “Of Money”:

“From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.”

The first sentence is fine. But the second sentence is very clearly a problem.

Was it Friedman who said “we have only advanced one derivative since Hume”?

OK, so let’s see the whole relevant quotation from Hume’s essay “Of Money.”

Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging everyone to pay a greater number of these little yellow or white pieces for everything he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.

To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue.

He carries his money to market, where he, finds everything at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour. And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three-sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

So Hume understands that once-and-for-all increases in the stock of money and in the price level are neutral, and also that in the transition from one price level to another, there will be a transitory effect on output and employment. However, when he says that the good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of industry in the nation, he seems to be suggesting that the long-run Phillips Curve is actually positively sloped, thus confirming Milton Friedman (and Nick Rowe and Scott Sumner) in saying that Hume was off by one derivative.

While I think that is a fair reading of Hume, it is not the only one, because Hume really was thinking in terms of price levels, not rates of inflation. The idea that a good magistrate would keep the stock of money increasing could not have meant that the rate of inflation would indefinitely continue at a particular rate, only that the temporary increase in the price level would be extended a while longer. So I don’t think that Hume would ever have imagined that there could be a steady predicted rate of inflation lasting for an indefinite period of time. If he could have imagined a steady rate of inflation, I think he would have understood the simple argument that, once expected, the steady rate of inflation would not permanently increase output and employment.

At any rate, even if Hume did not explicitly anticipate Friedman’s argument for a vertical long-run Phillips Curve, certainly there many economists before Friedman who did. I will quote just one example from a source (Hayek’s Constitution of Liberty) that predates Friedman by about eight years. There is every reason to think that Friedman was familiar with the source, Hayek having been Friedman’s colleague at the University of Chicago between 1950 and 1962. The following excerpt is from p. 331 of the 1960 edition.

Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many per cent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.

The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation price rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the expectational stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.

This was certainly not the first time that Hayek made the same argument. See his Studies in Philosophy Politics and Economics, p. 295-96 for a 1958 version of the argument. Is there any part of Friedman’s argument in his 1968 essay (“The Role of Monetary Policy“) not contained in the quote from Hayek? Nor is there anything to indicate that Hayek thought he was making an argument that was not already familiar. The logic is so obvious that it is actually pointless to look for someone who “discovered” it. If Friedman somehow gets credit for making the discovery, it is simply because he was the one who made the argument at just the moment when the rest of the profession happened to be paying attention.

What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.


From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.

Ludwig von Mises Explains (and Solves) Market Failure

Last week Major Freedom, a relentless and indefatigable web-Austrian troll – and with a name like that, I predict a bright future for him as a professional wrestler should he ever tire of internet trolling — who regularly occupies Scott Sumner’s blog, responded to a passing reference by Scott to F. A. Hayek’s support for NGDP targeting with an outraged rant against Hayek, calling Hayek a social democrat, a description of Hayek that for some reason brought to my mind Saul Steinberg’s famous New Yorker cover showing what the world looks like from 9th Avenue in Manhattan.


Hayek was not a libertarian by the way. He was a social democrat. If you read his works closely, you’ll realize he was politically leftist very soon after his earlier economics works. Hayek was actually an economist for only a short period of time. He soon became disenchanted with free market economics, and delved into sociology where his works were all heavily influenced by leftist politics. He was an ardent critic of government, but not because he was anti-government, but because the present day governments were not his ideal.

Hayek favored central banks preventing NGDP from falling yes, but he was a contradictory writer. It is dishonest to only focus on the one side of the contradiction that supports your own ideology. If you were honest, you would make it a point that Hayek also favored monetary denationalization, of competitive free market currencies. He wrote a book on that for crying out loud. His contradictions are “Hayekian.” NGDP targeting is merely the Dr. Jekyll to his Mr. Hyde.

Then responding to the incredulity of another commenter at his calling Hayek a social democrat, the Major let loose this barrage:

From [Hans-Hermann] Hoppe:

According to Hayek, government is “necessary” to fulfill the following tasks: not merely for “law enforcement” and “defense against external enemies” but “in an advanced society government ought to use its power of raising funds by taxation to provide a number of services which for various reasons cannot be provided, or cannot be provided adequately, by the market.” (Because at all times an infinite number of goods and services exist that the market does not provide, Hayek hands government a blank check.)

Among these goods and services are:

“…protection against violence, epidemics, or such natural forces as floods and avalanches, but also many of the amenities which make life in modern cities tolerable, most roads … the provision of standards of measure, and of many kinds of information ranging from land registers, maps and statistics to the certification of the quality of some goods or services offered in the market.”

Additional government functions include “the assurance of a certain minimum income for everyone”; government should “distribute its expenditure over time in such a manner that it will step in when private investment flags”; it should finance schools and research as well as enforce “building regulations, pure food laws, the certification of certain professions, the restrictions on the sale of certain dangerous goods (such as arms, explosives, poisons and drugs), as well as some safety and health regulations for the processes of production; and the provision of such public institutions as theaters, sports grounds, etc.”; and it should make use of the power of “eminent domain” to enhance the “public good.”

Moreover, it generally holds that “there is some reason to believe that with the increase in general wealth and of the density of population, the share of all needs that can be satisfied only by collective action will continue to grow.”

Further, government should implement an extensive system of compulsory insurance (“coercion intended to forestall greater coercion”), public, subsidized housing is a possible government task, and likewise “city planning” and “zoning” are considered appropriate government functions — provided that “the sum of the gains exceed the sum of the losses.” And lastly, “the provision of amenities of or opportunities for recreation, or the preservation of natural beauty or of historical sites or scientific interest … Natural parks, nature-reservations, etc.” are legitimate government tasks.

In addition, Hayek insists we recognize that it is irrelevant how big government is or if and how fast it grows. What alone is important is that government actions fulfill certain formal requirements. “It is the character rather than the volume of government activity that is important.” Taxes as such and the absolute height of taxation are not a problem for Hayek. Taxes — and likewise compulsory military service — lose their character as coercive measures,

“…if they are at least predictable and are enforced irrespective of how the individual would otherwise employ his energies; this deprives them largely of the evil nature of coercion. If the known necessity of paying a certain amount of taxes becomes the basis of all my plans, if a period of military service is a foreseeable part of my career, then I can follow a general plan of life of my own making and am as independent of the will of another person as men have learned to be in society.”

But please, it must be a proportional tax and general military service!

The disgust felt by the Major for the crypto-statist Hayek is palpable, reminiscent of Ayn Rand’s pathological abhorrence of Hayek for tolerating welfare-statism. Ah, but Ludwig von Mises, there is a man after the Major’s very own heart.

In distinct contrast, how refreshingly clear — and very different — is Mises! For him, the definition of liberalism can be condensed into a single term: private property. The state, for Mises, is legalized force, and its only function is to defend life and property by beating antisocial elements into submission. As for the rest, government is “the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen. The essential feature of government is the enforcement of its decrees by beating, killing, and imprisonment. Those who are asking for more government interference are asking ultimately for more compulsion and less freedom.”

Moreover (and this is for those who have not read much of Mises but invariably pipe up, “but even Mises is not an anarchist”), certainly the younger Mises allows for unlimited secession, down to the level of the individual, if one comes to the conclusion that government is not doing what it is supposed to do: to protect life and property.

Well, the remark about Hayek’s support for — perhaps acquiescence in would be a better description — conscription (see the Constitution of Liberty) reminded me that in Human Action no less – for the uninitiated that’s Mises’s magnum opus, a 900+ page treatise on economics and praxeology — Mises himself weighed in on the issue of military conscription.

From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace. But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

There it is. With characteristic understatement, Ludwig von Mises, a card-carrying member of the John Birch Society listed on the advisory board of the Society’s flagship publication American Opinion during the 1960s, calls anyone opposed to conscription an abettor of those aiming at the enslavement of all. But what I find interesting in Mises’s diatribe are the two sentences before the last one in the paragraph.

He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government.

Here Mises says that we have to defend ourselves to maintain our freedom, otherwise we will be enslaved. OK. And then he says that voluntary self-defense will not work. Why won’t it work? Because the market isn’t working. And what causes the market to fail? “Isolated attempts on the part of each individual to resist” will fail. In other words, defense is a public good. People will free ride on the efforts of others. But Mises has the solution. Impose a draft, and compel the able-bodied to defend the homeland and force everyone to pay taxes to finance the provision of the public good, which the unhampered free market is unable to do on its own. Of course, this is just one example of market failure, but Mises doesn’t actually explain why the provision of national defense is the only public good. But, analytically of course, there is no distinction between national defense and other public goods, which confer benefits on people irrespective of whether they have paid for the good. So Mises acknowledges that there is such a thing as a public good, and supports the use of government coercion to supply the public good, but without providing any criterion for which public goods may be provided by the government and which may not. If conscription can be justified to solve a certain kind of public-good problem, why is it unthinkable to rely on taxation to solve other kinds of public-good problems, whose existence Mises, apparently unbeknown to himself, has implicitly conceded?

With the logical rigor that his acolytes find so compelling, Mises concludes this particular diatribe with the following pronouncement:

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.

Let’s think about that one. “Every step a government takes beyond the fulfillment of its essential function of protecting the smooth operation of the market economy against aggression . . . is a step forward on a road that leads into the totalitarian system where there is no freedom at all.” Pretty scary words, but how logically compelling is this apodictally certain praxeological law?

Well, I live in Montgomery County, Maryland, a short distance from US Route 29. When I visit Baltimore about 35 miles from my home, I often come back from Baltimore via Interstate 70 which starts at a park-and-ride station near Baltimore and continues for about 2153 miles to Cove Fort, Utah. I am happy to report that I have never once driven from Baltimore to Cove Fort. In fact the first exit off of Interstate 70 puts me on US Route 29. What’s more, even if I miss the exit for Route 29, as I have done occasionally, there are other exits further down the highway that allow me to get to Route 29; just because I drive the first four miles on Interstate 70 from Baltimore, it doesn’t necessarily follow that I will wind up in Cove Fort, Utah. So this particular example of the supposedly impeccable Misesian logic sure seems like a non-sequitur to me.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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