Well done, Ramesh. Both your original post and this follow-up are spot on. It is strange that Milton Friedman made his reputation showing how the Fed's unwillingness to create new money to meet the increase in demand for it created by financial crises and its utter passivity in response to exceptionally high unemployment were the primary factors causing the great depression; and yet now it is conservative orthodoxy that we should repeat those same mistakes (on a smaller scale).

Ramesh is correct. Hayek writes about monetary disequilibrium in his 1929/1933 book _Monetary Theory and the Trade Cycle_ and discusses monetary & fiscal efforts to combat below productivity-norm deflation in many places, as early as 1931 and as late as 1985.

Ramesh still hasn't gotten the basic flaw in Hendrickson's (and, consequently, his own) analysis, which is that an increased demand for liquid savings is equivalent to a decreased demand for consumption and investment. You can't simultaneously consume/invest your wealth and stuff it in the mattress. And if there's an economy-wide decrease in the demand for consumption and investment, then of course the economy will shrink, and rightly so. And if the shrinking of the economy is appropriate, then citing Friedman's equation is meaningless.

The increased demand for money to use as liquid savings will be met by the decreased demand for money to use as a medium of exchange--there's no need for the Fed to increase the money supply. The only purpose of doing so is to manipulate people into spending/investing now, either because they fear future inflation, because they want to take advantage of a new, government-fueled bubble, or because they've been fooled into feeling richer than they actually are. But that's just Keynesianism by other means. Only malinvestment can result from government interventions that interfere with individuals' judgments on if, when, and how to deploy their wealth in the economy.

The rejoinder of the pro-QEII side tends to be that when you have a fiat currency, refraining from changing the money supply is just as much a decision/intervention as changing it. But that ignores that current prices, interest rates, etc., reflect the current money supply, and therefore allow people to more easily make rational economic decisions, without having to wonder about the effect of change.

Mr. Ponnuru,

It is nice that you have read through comments to address them. But your argument is still thoroughly unconvincing. Let's say that the real problem is the expansion of money supply, moving up prices during a boom beyond realistic expectations. When the bubble bursts and there's a margin call, of course there will be a huge demand for money. All the people that overinversted in the wrong things are going to want more money, but these are precisely the people who should not be bailed out. As they need money badly, the price of money goes up and there is price deflation. If you print money to satisfy this demand, you're just keeping prices artificially high. In a market desperately in need of correction, by raising the price of money, the central bank is trying its best to keep the price of money low. All because of some supposed link to deflation in the Great Depression.

I guess the upshot is, the market is based on a certain supply of money. Why print out so much more to further distort the market? A central bank should, if it is to exist at all, not run around like a chicken with its head cut off any time the value of money increases. By printing all this money, we are simply distorting the primary function of money in a capitalist system.

Allesnarf - As before, good points, but I think there is a foundational flaw in your approach best illustrated by your statement ... "At bottom, the reason I find these arguments from conservatives so disheartening is that they assume what conservatives rightly reject the rest of the time: that the economy can be "managed", and that intervention can outsmart the market and do more good than harm."

The fact is that the government runs the U.S. monetary system through the Fed. There is no 'natural' or 'market' monetary system out there that the Fed is screwing up. There is nothing but the government monopoly. That being said, the government has no choice but to manage the monetary system (or go back to the gold standard).

Imagine if the government nationalized health care and all medicine was produced by the government. Now there is an outbreak of whooping cough and it is proposed that the government produce more whooping cough vaccine than usual. Is the proper conservative response to say that it is disheartening to hear that people think that health care can be managed and the only thing to do is let the disease run its course until enough people have died so that the maladjustement in the health of the nation has been fixed? Or is the best response to realize that there is an increase in demand for this product, the government makes it, and so making more will lead to the less painful adjustement to the new equilibrium?

That is why the conservative who did more than any other economist to bring this country back to free market principles said, when asked what the Japanese should do in a position very similar to ours, they should do their own QE2 External Link  Or is Milton Friedman consdered just another foolish liberal now?

Also, a goverment maladjustment is not the same thing as a bubble. If we have to wait until all the government induced distortions you mention cease to be before the economy can recover, then we will never recover.

Counterfactual:

I tried to anticipate that point in the final paragraph to my first post. And I take the argument that in an expanding economy the money supply would ideally expand as well. But it doesn't follow from the fact of a fiat currency, or from the argument that the money supply should expand when the economy is genuinely expanding, that the money supply should also expand when the economy is contracting, or that a fiat currency with constant tinkering is no different from a fiat currency held constant over long periods.

I also take the point that eliminating all government-caused distortion is not an achievable goal in the forseeable future. But we should at least be working to pare the number and size of distorting policies, not adding new ones in a vain attempt to offset the negative effects of the old.

Perhaps you can answer this: Are people acting irrationally in increasing their liquid savings and decreasing their consumption and investment? If not, why should we attempt to interfere with them? The answer, I believe, is because politicians want to goose short-term employment and GDP numbers, at the expense of stable investment and long-term wealth. It's the monetarist equivalent of paying people to dig holes and fill them in again.

Allesnarf - I don't think that people are acting irrationally in trying to increase their holding liquid holdings and decrease spending, just as I don't think people who ran to the bank and closed out their checking and savings accounts in the early 1930's were acting irrationally. And yet the interaction of people's rational desire for safe liquid assets in a time of financial uncertainty combined with the Fed's decision to not create more of these assets to meet this demand lead to economic disaster in the 30's

I don't wish to interfere with people's rational desire to hold more liquid assets, I wish the government to recognize that rational desire, realize they have assumed a huge part of the responsibility for creating those liquid assets people now desire when they nationalized the financial system in 1913 (when the Fed was created), and act accordingly.

I actually agree with much of your skepticism of government/fed micromanagement of the macroeconomy and don't think that the
fed should respond to every little hiccup. But what is going on now is not a hiccup, or even a normal recession; it is the fall out of an extraordinary financial panic across the system of the like we have not seen for 70 years. We are getting that bad feedback mechanism we got in the 30's that the cutback in consumption/investment necessary to rebalance the system by itself is so huge the economy tanks, so people lose more confidence (rationally) and cut spending more, causing the economy to tank more, and so on. Or instead, the Fed can create more of the asset (money) that people desire and short-circuit the panic/feedback mechanism.

Of course, creating money does usually run the risk of creating inflation. Luckily(?). the economy has been so bad for so long, that risk is much reduced. To put it in your terms, sometimes the short-run can get so bad that it bleeds over into the long-run, and boosting the short-run results will both make the long-run get here sooner and be better when it does. Being aware that usually the government is just trying to goose the system to make things look good before the next election, I am perfectly happy to make a deal with you that the Fed only does this during once every 70 year panics, and holds to the slow and steady the other 69 years.