A Challenge to Much That You Believe About the Fed

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John Tamny, of Forbes and RealClearMarkets, has penned a highly original and stimulating look at the economics of money and banking: Who Needs the Fed? I sang the praises of his remarkable Popular Economics when that came out, and now this just-published book has me singing them again, in a new key.

Let me note up front that there are substantial parts of this book with which I, so far at least, disagree. I have exchanged some emails with Mr. Tamny on these issues and nothing has been resolved. This is a not A Bad Thing: it can be actually helpful to follow a rational person's thinking when you disagree with the conclusion he reaches.

In this case, the disagreement is about inflation. Mr. Tamny thinks the Austrian theory of what inflation is, and how it works, is flawed (I don't). Surprisingly, he argues that expanding the fiat money supply does not affect things much. It mainly leads people to use a different money (e.g., foreign currency).

The German hyperinflation? He holds that in actual commercial transactions, the hyperinflated Marks were scarce, because no one accepted them. An interesting idea, but I'm not sold on the whole idea of "money-as-yardstick," according to which the making of more yardsticks threatens nothing (and accomplishes nothing).

But, as a whole, the book's viewpoint is true and right. The rare virtue of Who Needs the Fed? is its ability to penetrate to fundamentals. Here's a non-exhaustive list of some of these fundamentals:

Wealth is created. Government does not create, it obstructs.

Growth economics is all about reducing the barriers to production

True, that. Production must precede consumption. As Ayn Rand said, you can't eat the cake before it's been baked. Keynesians please take note. The fundamental fact of economics is not: "scarcity" - which takes the fantasy of unlimited wealth as the standard, then judges what we have as falling short of the fantasy - the fundamental fact of economics is that wealth has to be produced.

Economics is the science of production for the market, not the science of "things you resort to when manna does not fall from heaven."

Credit is real resources labor, materials, factories, etc. - not money.

Remember, it's not dollars that are borrowed but the real resources that dollars are exchangeable for

... credit is not money. If it were, the "easy credit" that many-who-should-know-better clamor for would . . . be as simple as printing lots of money. In fact, credit is always and everywhere the actual resources tractors, cars, computers, buildings, labor, and individual credibility created in the real economy.

The pursuit of credit is actually the pursuit of the resources . . . necessary for entrepreneurs and businesses to turn concepts into reality.

The interest rate is a price set by objective factors- not by creditor's greed or the Fed's whim:

. . . the rate of interest [is] a price meant to bring savers together with borrowers. If this rate is distorted by governmental decree, the odds of exchange decrease. For credit to be "easy," the price of credit must reflect both the needs of those who seek to access it and the needs of those who have it. Put more plainly, the price of credit should be set in free markets

Banking should be totally free.

Free markets should apply to banking just as they do to any other industry sector

John Tamny is one of the few men who, when they say "free markets" mean free markets.

All government spending, not just deficits, comes at the expense of the private sector

...government spending is the opposite of stimulation. It is a tax on real resource creation.

All government spending should be viewed as deficit spending (even that which is constitutional) simply because governments are consuming from the private sector first. . . . [G]overnment spending is what we suffer in the here and now. 

The longer term effects of government spending, Tamny notes, are the never-to-be funded innovations, Bastiat's "that which is not seen":

Government consumes credit that would otherwise flow to cancer cures, transportation innovations like private jets, and technological innovations that would make the Internet seem quaint.

Government intervention in the economy is immoral

The wealth they [the Clintons and other politicos] enjoy is the result of the federal government confiscating it from its actual creators. The Clintons are posh and supercilious, but their grand lifestyle is directly attributable to the ability of the political class to plunder America's truly productive.

When politicians talk up 'stimulus' spending, it is realistically code for a redistribution of the economy's resources by a political leviathan that is being enriched on the backs of the American people.

There is much in this book that will make you question conventional wisdom, even if you are already a staunch advocate of laissez-faire capitalism. For example, take banks' influence on the economy. Did you know that banks supply only 15% of the credit extended in this country?! I didn't. Tamny argues that the central bank-the Fed-has far less impact than people imagine it does, though he's very clear that that impact is all to the bad.

Really eye-opening, is his attack on the idea of "the money-multiplier." That's the belief, held by nearly everyone, that banks lend out a high multiple of the money they take in - a multiple of the leverage inherent in keeping only a portion of deposits on reserve. The "money-multiplier" is supposed to result from the fact that money loaned out goes back into the banking system, where most of it is re-loaned. Then most of that is re-loaned, etc.

But Tamny argues that the idea of such money-multiplying confuses dollars with real wealth - the machinery, equipment and labor that credit gives one access to. The same tractor, for instance, can't be used by many individuals at once. So, while the re-loaning may expand nominal bank balances, it does not and cannot expand actual credit. Credit is the resources. The amount of resources available is what it is; it cannot be multiplied by acts of the banking system.

What can be expanded is the use of these resources, by, in effect, borrowers time-sharing them, each borrower having the resources available when he needs them (which is not all of them right away). He draws an analogy to the business model of NetJets, a company that "sells fractional ownership of the jets in its fleet of seven hundred planes." Many thousands of fractional owners can have the use of a jet when they need it, even though NetJet has only 700 planes.

He uses the NetJets example to demolish the opponents of fractional reserve banking, notably the anarchist Murray Rothbard:

As the late Murray Rothbard, a true-blue Austrian, long ago put it, "Fractional reserve banks . . . create money out of thin air. Essentially they do it in the same way as counterfeiters." Underlying Rothbard's assertion is a fanciful belief that the alleged "money multiplier" is a fact. It's fiction.

The essential here is an oft-ignored reciprocity of the market:

Someone can borrow only if someone else is willing to cease using money in the near term. . . . For someone to lend, that someone or business must give up, at least in the near term, the resource access that those dollars represent.

I would add that the re-loans come from the borrower's deposit balance-i.e., the part of the first loan that would otherwise be sitting idle in the bank, not yet being called upon to pay for tractors, labor, etc. So, what is re-loaned is what is not being spent, and what is being spent is not being re-loaned.

Those who are opposed to fractional-reserve banking must be able to answer the challenges raised in Tamny's chapter "Banks Don't Multiply Money and Credit."

Also likely to cause controversy are Tamny's arguments that a) the Fed isn't that influential in the economy, and b) the housing crisis was not caused by credit expansion. I lean against his views here, but I have to admit his arguments give me pause.

In short, this is a book that is will make you think. Even if you end up disagreeing with the "heretical" positions he takes, John Tamny's first-handed challenge to familiar ideas, his new observations, and the fresh perspective he offers from within the pro-capitalist camp will provide you with inestimable value.

Harry Binswanger is an Objectivist philosopher, and was a close associate of Ayn Rand. He blogs at www.hbletter.com.  

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