Thursday, December 8, 2011

The Market Monetarist Illusion

Ever since reading George Selgin's "Theory of Free Banking"  I have held  the view that in an unhampered free market that banks,   operating on  fractional  reserve principals ,   will  trend to stabilize AD by lending out excess  reserves in the face of increased  demand for money by their customers.

To some degree that has  made me supportive of efforts by the central bank  to  increase the money supply (and lower interest rates) in the face of increased demand for money as a "second best"  option in a world without free banks.      This support was always lukewarm because absent the profit motive the central banks will likely both misdirect the increased lending for political purposes   (as in the housing boom)   and by acting as a lender of last resort introduce issues of "moral hazard"  into the heart of the financial system (as in the 2008 bailout).

The recent crisis has revealed a bigger hole in the ability the central bank to stabilize the economy.    Following the housing bust and the financial panic of 2008 businesses were not surprisingly very cautious to invest and this led to falling demand for labor and rising unemployment.    The fed lowered interest rates to close to zero to try to encourage borrowing for investment purposes.   However even at this "zero-bound"   investment was insufficient to prevent a deep recession.   NGDP fell in absolute terms in 2008 and has remained below trend since.    Wages did not fall   in the face of this   decline in demand with the inevitable result has been high unemployment.

Given that conventional monetary policy has reached the end of the road what is the solution ?    The Market Monetarists say that all we need to do is to  increase the money supply via the purchase   of assets until NGDP is back on target and the economy will right itself.      I do not believe they are right.     Short of direct government intervention in the labor market as the Keynesians call for then the only way to increase employment is to increase the demand for labor.    We cannot lower interest rates any further so we can not induce business to invest any more in that way.   The  other way to increase the demand for labor is to reduce its price.    This has not happened likely because of UI and minimum wage regulations. 

The only way that what the Market Monetarists are proposing will work is if the increase in the money supply increases inflation and in effect makes the real rates of interest negative,   This will indeed cause investment to increase short term but at the medium-term cost of higher inflation expectations and a likely  return to stagflation of the 70's.

The alternative is to attack the causes not the symptoms.    Free the markets.   Abolish  regulations that are preventing business right now from starting up ,   meeting consumer needs and increasing the demand for labor.      Review  the minimum wage laws and extended UI rules that prevent wages from falling to match the reduced demand.

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