2011-01-03

Bill Woolsey on Monetary Theory and Interest Rates

On December 28th (I was out of town, unfortunately), Bill Woolsey wrote a fantastic primer on monetary economics at his blog. I have been a big fan of Woolsey's comments on other bloggers' blogs for quite some time (even when I don't always agree), but I only recently discovered his blog. I highly recommend it, by the way.

Woolsey's explanation is quite comprehensive, and most of it cannot and will not be argued with. I do take minor exception to his first three paragraphs, however:

Perhaps it is my imagination, but there appears to be a notion among some conservatives and libertarians that the "free market" response to an increase in saving is for production to fall to match demand, and for firms to lay off their least productive workers. The more productive workers remain employed and continue to consume and save as they choose. If the more productive workers choose to consume more (and there is no reason they should) then production will expand and the least productive workers will again be hired.
Usually, this account is combined with the notion that the saving involves paying down excessive debt accumulated in the past. The suffering of the unemployed today is the inevitable consequence of the excessive debt built up in the past. Only after those who remain employed have paid down their excessive debts can they begin to spend again, so that employment can recover.
WRONG!
Woolsey then goes on to quite perfectly describe the ideal free-market macro situation, in which interest rates respond to market conditions and then market conditions respond to interest rates, and then equilibrium is re-established. Once again, his explanation on that level is among the best I've seen in the blogosphere, so please check it out.

He does point out an important problem with a casual Austrian School approach to the business cycle; namely, if people are out of work and production falls, how are people going to pay off those nefarious debts? Good point!

Broadly, I think Woolsey is right to point out that this is a catch-22. Once production falls, it will have to pick back up again before any of that debt can be paid off.

Where I (perhaps) disagree with Woolsey is that it is incumbent on central banks to solve this problem. Here's an imaginary scenario to consider:

Suppose the Fed set the interest rate at zero, and then ceased all OMOs and never adjusted the interest rate ever again. After a short while, (in particular, after the market finally understood that the Fed was not going to set interest rates or change the money supply anymore) interest rates would rise on the market despite the 0% Federal Reserve recommendation; lending would correspond to only those loans that were deemed by the market to be profitable; banks would carefully ensure that they could cover their reserves or else risk a bank run and an end to their businesses. In short, the market would behave entirely as though no central bank actually existed.

Now, we have heard many times that loose monetary policy caused the recent recession. Theoretically, if interest rates are set (by the Fed) "too low," then there is nothing to stop the market from raising interest rates on its own. Except that there is: The Fed manages the money supply through its relationship with a few major banks in order to ensure that banks can make enough easy Fed money that they are willing to keep their consumer interest rates nice and low. You can think of it as subsidized credit.

Why am I saying all of this? Well, I get the feeling that Woolsey's approach is that since we have a central bank, we have to play by its rules, at least until we get rid of it. The implication there - in light of his first few paragraphs quoted above - is that anyone who feels that the Fed causes the problem and then prevents the "solution" from occurring is not as free market as they think.

Well, I think Woolsey is absolutely correct about the production problem he has pointed out; but I think this doesn't really address the core issue that central banks are causing these problems and cannot pretend to fix them. And I think Woolsey is sympathetic to this view. (And for all I know, Scott Sumner might also be.)

So what we have here is ANOTHER catch-22: this "quasi-monetarist" approach is the problem of the benevolent dictator. Once the Fed starts managing one market process, it must necessarily find itself managing all sorts of other market processes until the whole system is wrapped up in central management. So it's hard to produce a "best choice" when everything falls short of what would occur in the market naturally. It's hard for quasi-monetarists, it's hard for monetarists, it's hard for Austrians, and it's hard for Keynesians.

What a mess!

Anyway, I'd like to thank Bill Woolsey for taking the time to explain all that so effectively. He has obviously gotten my thoughts rolling, as he always does.