In a world of uncertainty, waste—the destruction of value—is inevitable. Human action, which aims to replace inferior circumstances with superior circumstances, often involves laboring to transform scarce resources from a less useful form to a more useful form. For example, I transform money earned by my labor into raw beef (by using time and gasoline to drive to the supermarket and engaging in exchange), then I transform the raw beef into a medium-well hamburger through the time-consuming process of cooking. If after I eat the hamburger I wish I had done something else with the money and time (say, bought a chicken), I will regret my course of action and feel I’d wasted both.

We have all devoted time and resources to some project that we later realized was the wrong project. That’s the price of imperfect knowledge, which plagues all human beings. If we’re lucky some of the resources we used might be salvageable and put to other purposes, but the time, effort, and other resources are gone.

The same thing of course occurs in commercial production. An entrepreneur buys inputs and hires labor, thinking the finished product will bring a price that covers costs and yields a competitive return—only to find that people don’t want the product, or not badly enough to pay the anticipated price. The loss represents the destruction of value: The value of the inputs before the transformation took place turned out to be greater than the value of the finished product.

As I say, this happens because our knowledge is imperfect. It’s too bad, but perhaps not a tragedy—just a fact of life we learn to live with and minimize. The tragedy occurs when government intervention distorts price signals and induces people en masse unwittingly to make value-destroying plans. That’s part of the story told by the Austrian theory of the business cycle. In the present economic case the Federal Reserve’s low-interest-rate policy in the early 2000s and several federal agencies’ decade-long easy-housing policies induced builders to produce too many houses relative to what the demand would have been without those unsustainable policies. The result was the infamous housing boom and inevitable bust. With housing prices apparently on an unstoppable upward trajectory, and government-backed Fannie Mae and Freddie Mac—not to mention too-big-to-be-allowed-to-fail banks—willing to buy lenders’ mortgages no matter how shaky, builders and buyers were found in great abundance. Buying more house than one could afford seemed smart when one could get a low teaser rate on an adjustable-rate mortgage for a low-to-no-down-payment home and expect its price to rise significantly in six months. When the higher rate kicked in, one could refinance or sell and walk off with the equity.

But when interest rates rose, the bubble burst, and demand plummeted, this smart scheme turned sour. Houses stood unsold, and many people couldn’t pay their mortgages, refinance, or sell at a profit. Foreclosures skyrocketed and the multitude with underwater homes simply disappeared, leaving banks holding a slew of vacant houses that cost money in taxes, code violations, and so on.

As a result, banks now would rather donate the properties to government-created nonprofit land banks and pay for the demolition than hold them and hope for future sales. This is happening in Cleveland, and the Washington Post reported that similar programs were being discussed elsewhere.

How does this relate to the waste identified by the Austrian business-cycle theory? To the extent the homes were vacated and allowed to deteriorate because of the process described above, the demolitions represent destruction of value attributable to government. In the absence of the unsustainable bubble-inflating policies, some of those houses wouldn’t have been built.

In the case of older homes, fewer newly built houses would have competed with them in the real estate market. They would still be occupied and therefore would have been maintained. (There would have been no Great Recession and high unemployment.) Demolition would not have been an attractive alternative.

The tragedy is that because of government policy, demolition is the most attractive alternative. Think of the resources and labor—now seen to have been squandered—that went into making each house. Imagine what products might have been created instead. It’s worse than that: Products always summon complementary products. A housing boom stimulates the production of related shopping centers, office parks, and myriad smaller facilities and products. The resources required to make those things also would have gone elsewhere. Now all those resources, along with much labor and time, are gone because people in government thought they knew how to plan the housing market.

* * *

Georgia and Alabama have joined Arizona in enacting a tough law directed at undocumented immigrants. As Scott Beaulier, Darrick Luke, and Daniel Smith demonstrate, this is already damaging their economies.

Andrew Morriss has been to Graceland, where he found that the lap of luxury in which its fabulously wealthy late resident lived doesn’t look so luxurious today.

Conventional wisdom holds that without the welfare state, the poor would be in dire straits. But what if, as Gary Chartier suggests, government is responsible for the poor’s condition in the first place?

If public policy created the housing bubble, the bursting of which has caused so much misery, can it really be a good idea to reinflate the bubble? Richard Fulmer says that according to political logic, the answer is yes.

The more government controls the curriculum, the more inimical schooling becomes to education. Peter McAllister explains.

The eurozone is in trouble, leading Robert Murphy to explore the possibility that it was a colossal mistake in the first place.

Regulation at the national level gets the lion’s share of attention from market advocates. But let’s not overlook the planning mentality more locally. Sam Staley surveys the taxicab industry.

Here’s what our columnists have whipped up: Donald Boudreaux audits the economics textbook writers. Robert Higgs explains why there’s so little investment. John Stossel brands government a job destroyer. Charles Baird looks at the latest outrage against free speech. And Tyler Watts, bombarded with claims that we couldn’t live without FEMA, responds, “It Just Ain’t So!”

Books on libertarianism, the economy, socialism, and the threat to freedom occupy our reviewers.

—Sheldon Richman

srichman@fee.org

It is as though the Fed were riding on the back of a double-headed monster. It cannot hang on forever, but it cannot dismount the beast without being devoured. As it is, the U.S. Treasury depends on ZIRP to fund America’s ballooning debt. When investors flee an enfeebled dollar the Fed is likely to be the “buyer of first resort” so that the price of Treasurys does not fall, pushing up interest rates. (So far Treasurys with low yields are still in high demand.) So with the Fed insisting that short-term interest rates will remain near zero “for an extended period,” a phrase used for the past two years, a new round of QE is almost inevitable.

For its part, QE involves flooding financial institutions with excess liquidity to try to flatten out the yield curve and depress long-term interest rates in hopes of sparking a recovery. But QE has created a massive overhang of excess reserves in the banking system that constitute repressed price inflation. And the sums involved are truly staggering: The Fed has injected at least $2.3 trillion into the financial system since Lehman Brothers collapsed in September 2008.

From late 2008 through March 2010 the Fed bought longer-term securities worth $1.7 trillion (QE1). This included purchases of $500 billion in mortgage securities and $100 billion in agency debentures with a target of $1.25 trillion for mortgage debt. Purchasing mortgage-backed securities and bailing out AIG and Bear Stearns, as well as buying other securities, led to a 140 percent increase in the monetary base.

In November 2010 the Fed began QE2 by buying an additional $600 billion in longer-term Treasury securities, a program that officially expired at the end of June. Yet the Fed has indicated it will continue buying Treasurys using proceeds from maturing debt it already owns.

Stealth Easing

With over $112 billion of the Fed’s government bond holdings maturing over the coming 12 months, replacement alone would involve purchasing over $9 billion of Treasurys each month. It also has more than $914 billion of mortgage-backed debt and $118 billion of debentures issued by government-sponsored enterprises (Fannie Mae and Freddie Mac). As such this is a “stealth” continuation of QE with only a limited, if any, decrease in the money-creation process.

For all the fanfare about QE, it must be said that it constitutes a last-gasp step and admission of the failure of other monetary policy tools. Consider the case of Japan. Its central bank, the Bank of Japan (BoJ), began asset purchases under QE to offset deflation and stimulate its ailing economy in early 2001. After nearly a decade of setting interest rates near zero the BoJ realized it had been unable to conjure up an economic recovery. Then after five years of gradually expanding its bond purchases, the BoJ exercised an exit strategy from QE in 2006, only to begin again.

Last March the BoJ increased its QE program from ¥5 trillion to ¥10 trillion (about $130 billion) scheduled until the end of 2012. Recently it announced another expansion to ¥15 trillion ($183 billion).

Incentives vs. Growth

A child untutored in economics might think it makes no sense to continue massive increases of liquidity into the economy that have been ineffective for so long. But most central bankers and many economists argue that previous amounts were too little and more is needed.

The incentives that QE and ZIRP create for commercial banks make it easy to see why these policies cannot promote economic growth. On the one hand, low interest rates reduce the cost of borrowing, which should encourage more investment spending. But on the other, commercial banks pay almost nothing to borrow yet receive interest payments from the Fed to hold excess reserves, making them unlikely to extend new loans.

A sufficiently high interest rate paid on bank reserves will induce banks to choose a risk-free interest-bearing asset rather than lending to private-sector borrowers. And so it is that commercial banks are earning record profits while making very few new loans.

Exit Strategy?

The question of whether the Fed or the BoJ has an effective “exit strategy” from monetary expansion using near-zero interest rates and quantitative easing remains open. One possibility for the Fed is to engage in repurchase agreements (repos) to remove some of the excess liquidity that it pumped into the financial system.

These repos involve selling securities to commercial banks with the Fed agreeing to buy them back at a higher price at a later date. But once again commercial banks will find holding risk-free interest-bearing assets a much better bet than issuing new commercial loans.

In the end both QE and ZIRP have been ineffective in restoring economic vitality while also creating a massive overhang of repressed inflation. Most economists view business startups, especially small and medium-sized enterprises, as the key to economic recovery and growth. Yet QE and associated central-bank policies are diverting credit away from newly forming firms.

The Fed has now announced it will continue the “exceptionally” low short-term interest rates until the middle of 2013. This indicates that U.S. central bankers are unconvinced of the errors of their ways in their policy choices. That they are unwilling or unable to change course means the U.S. and Japanese economies are doomed to painfully slow economic growth for the foreseeable future.

In response to questions by U.S. Senator Jack Reed (D-RI), Bernanke joined in the chorus of those predicting skyrocketing interest rates in the United States and abroad if the federal government defaulted on its debt obligations because Congress did not raise the debt ceiling. It was not a given that the federal government would have defaulted if the ceiling had not been raised. But ignoring that fact, Bernanke argued that the “loss of investor confidence [following default] could potentially raise interest rates quite significantly. . . . But if interest rates rise, that’s clearly going to reduce investment, uncertainty will rise, that will reduce the abilityness [sic] of firms to hire and invest. . . . So I can only conclude that this would be very bad for—for jobs.”

Did the person supposedly in charge of determining interest rates in the United States through Federal Reserve credit creation really say that? What was the rationale for QE1 and QE2 (quantitative easing) if not to lower interest rates and promote economic prosperity? And who inspired that mistaken thinking? John Maynard Keynes, of course.

Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or lendable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall had explained. Therefore, in Keynes’s view, it is the responsibility of a central bank to increase its supply of money enough to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments. That is, money should become so plentiful that no one would be obliged to pay interest to borrow it. (Of course, Keynes here confuses money with savings or wealth.)

The money (cash) supply-and-demand theory of interest rates was the predominant view among Mercantilist thinkers from the sixteenth to eighteenth centuries. It was to correct that mistaken view that Hume, in his essay “Of Interest,” explained that although interest rates may be influenced temporarily by the abundance or scarcity of money, they are permanently determined by the flow of savings relative to their demand:

High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce [hence the desirability of demanding more loans]: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver [money]. Low interest, on the other hand, proceeds from the opposite circumstances: A small demand for borrowing; great riches to supply that demand; and small profits arising from commerce: And these circumstances are all connected together, and proceed from the increase of industry and commerce, not of gold and silver.

Hume’s elaboration on that point was the basis of subsequent classical writers’ explanation of interest-rate determination by the supply and demand for savings. Keynes, on the other hand, denied all such explanation and declared in his 1939 preface to the French edition of the General Theory that, in arguing that interest rates rather are determined by “the demand and the supply of money, that is to say [by] the demand for liquidity and the means of satisfying this demand [he is] returning to the doctrine of the older, pre-nineteenth century economists. Montesquieu, for example, saw this truth with considerable clarity—Montesquieu who was the real French equivalent of Adam Smith, the greatest of your [French] economists, head and shoulders above the Physiocrats in penetration, clear-headedness and good sense (which are the qualities an economist should have).”

Has Bernanke now abandoned his adherence to Keynes’s money, or liquidity supply-and-demand, theory of interest rates, or was he merely participating in the debt-default scare to further the federal government’s agenda of raising the debt ceiling to accommodate its profligate spending?

After all, Bernanke also acknowledged to Senator Reed that besides the Chinese, the Fed is “the largest holder of our Treasury debt.” Why wouldn’t the Fed simply cancel the Treasury’s debt and purchase some more to save the federal government from its predicted default? To support the political-posturing view of Bernanke’s statements, one could legitimately cite his similar proclamations in fall 2008 that without the Troubled Asset Relief Program (TARP), giving the Treasury secretary $700 billion to purchase “toxic assets” mainly from investment banks, businesses could not meet their payrolls. The claim wasn’t true. Businesses borrow from commercial banks, not investment banks, to meet payroll. And commercial banks rely mainly on the public’s deposits to lend to businesses. The public would not have stopped making deposits with banks had TARP not passed. Besides, then-Treasury Secretary Hank Paulson didn’t initially use the money for the bill’s stated purposes. But the scare worked to push Congress to vote for the legislation.

More likely Bernanke simply employed the common-sense view of interest-rate determination through the supply and demand for financial assets (interest rates thus being inversely related to the price of financial assets), which is the classical economics view, in contradiction to Keynes, but without consciously intending to be anti-Keynes. Buyers of such assets (IOUs) are the savers while sellers of financial assets are the borrowers. Clearly, many U.S. Treasury bond holders would be inclined to sell them should a default occur. Such selling would reduce their price and thus raise their yield (interest). Therein lies the contradiction of Keynes and the affirmation of the classical principle he denied—namely, that the supply and demand for savings are the principal or permanent determinants of interest rates. Bernanke couldn’t deny the obvious, even as he exaggerated the consequences of a government default.

So what if the U.S. defaulted on its debt obligations and the yield on its debt rose? Must all interest rates rise as a result of the nonzero default risk on Treasuries? Not necessarily. There would simply be a narrowing of the risk premium between U.S. government bonds and other private-sector securities. Treasury securities would lose their default-risk advantage over other securities but retain their liquidity-risk advantage, given the Federal Reserve’s readiness, hence commercial banks’ readiness, to redeem Treasury securities on sight. There is no reason that the default risk of the bonds and stocks of such corporations as Apple, Microsoft, Google, or Walmart should rise just because that of the U.S. government has risen. Thus the yield on private securities may decline (as investors flee Treasuries) while that on U.S. government securities rises, leaving the average unchanged.

Savers are constantly looking for instruments (financial assets) through which they can earn returns on their savings. There may be some diversion of savings into gold, driving up its price further. But investors in gold also know that, like all other commodities, the bubble created by current fears about Treasuries will also burst in due course. Thus the predicted skyrocketing of worldwide interest rates from a possible U.S. government debt default was an exaggeration. If interest rates rise it will be the result of a contraction in the rate of savings worldwide.

Besides, high interest rates, as Hume explained in his 1752 essay, are not necessarily injurious to a high rate of economic growth. It is high interest rates resulting from a contraction in savings that reduce economic growth. One easily can verify this from the level of interest rates in the United States during the economic boom from 2003 to the fall of 2008. The yield on a one-month Treasury rose steadily from 0.91 percent in May 2004 to 5.16 percent in June 2006 while the unemployment rate declined from 5.6 to 4.6 percent. On the other hand, the one-month rate stood at 0.02 percent in June 2011 because of the Fed’s massive injection of credit while the economy has continued to be mired in anemic growth and the unemployment rate has risen to over 9 percent.

Raising taxes to balance the federal budget would not necessarily lower interest rates. Rather, higher taxes would reduce disposable income and thus the flow of savings. The high level of government spending—financed either by debt or high taxes—would put pressure on interest rates to rise. It also would divert more savings from private-sector investments that would otherwise promote sustained employment and economic growth. These are the insights of classical macroeconomics that Keynes failed to appreciate and his modern followers continue to miss.

Current low U.S. interest rates are unsustainable. They are going to rise with or without an increase in the federal government’s debt ceiling. Savers will not forever endure the current negative real interest rates. Cutting federal spending is the surer path to resumption in robust economic growth and reduction in the rate of unemployment. As David Ricardo acutely observed in his 1810 pamphlet, “The High Price of Bullion”:

To suppose that any increased issues of the Bank [of England] can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, . . . is to attribute a power to the circulating medium [money] which it can never possess. Banks would, if this were possible, become powerful engines indeed. By creating paper money, and lending it at three or two per cent. under the present market rate of interest, the Bank would reduce the profits on trade in the same proportion; and if they were sufficiently patriotic to lend their notes at an interest no higher than necessary to pay the expences of their establishment, profits would be still further reduced; no nation, but by similar means, could enter into competition with us, we should engross the trade of the world. To what absurdities would not such a theory lead us! Profits can only be lowered by a competition of capitals not consisting of circulating medium. As the increase of Bank-notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest [permanently].

Experience around the world repeatedly has confirmed Ricardo’s warning against the belief in a central bank’s money creation as the engine of economic growth instead of the pursuit of policies that encourage increased private savings.

I have devised a simple plan for improving Americans’ health by drastically reducing everyone’s weight, thereby significantly increasing longevity and reducing medical costs. All we need to do is revalue the pound. Instead of a pound being 16 ounces, it will now be 32, cutting everyone’s weight in half. We adjust our bathroom scales, our weights drop, and our health is improved.

Of course this “solution” rests on two fallacies. First, it conflates measurement with what is measured. Adjusting my bathroom scale does not change my weight, only my perception of my weight.

Second, the solution confuses cause and effect. My weight is not necessarily the cause of my health or lack thereof; in fact my weight may be caused by my ill health—an injury that keeps me from exercising or a thyroid condition, for example. More commonly, good health is the result of acting responsibly for many years: moderating calorie and alcohol intake, eating the right foods, engaging in regular exercise, getting quality dental and medical care. Such actions are likely to result in both moderate weight and good health. But I can no more make myself healthy by adjusting my bathroom scales than a doctor can cure a child’s cold by adjusting the thermometer he uses to measure her fever.

The two fallacies are so obvious that no one could possibly fall for them, right? Sadly, no. Many brilliant people have fervently believed in nearly identical fallacies for decades and are even now basing our country’s monetary policy on them.

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760–1830:

If we seek—it would be wrong to do so—for a single reason why the pace of economic development quickened about the middle of the eighteenth century, it is to low interest rates we must look. The deep mines, solidly built factories, well-constructed canals, and the houses of the Industrial Revolution were the productions of relatively cheap capital.

John Maynard Keynes, making this same observation years before, concluded that simply by manipulating a country’s money supply and financial markets to artificially produce low interest rates, “deep mines, solidly built factories, well-constructed canals and houses” would spring into being. But Keynes confused “cheap capital” with easy money. Capital—inventories, pre-consumer goods, and the methods and means of production—cannot be conjured into being by manipulating interest rates. They can exist only through production and saving (deferred consumption).

Capital goods can be relatively cheap only if they are relatively plentiful. Increasing capital, all else equal, will lower interest rates. But interest rates are more than just a measure of capital availability; they also reflect lending risk. Risk in turn can be affected by such things as inflation and the reliability and efficiency of transportation, communication, and capital markets.

A lender would hardly agree to make a $100 loan unless he could reasonably expect to get at least $100 in purchasing power in return. If the government is debasing the currency, loans will be made only if interest rates are higher than the anticipated rate of inflation.

Costs and Lending Risks

Transporting goods by human or animal power is slow and costly. Sailing ships can carry far more goods far more quickly. Steam-powered ships are faster and more efficient still. Transportation costs, then, are inversely proportional to the level of technology. But costs also depend on the rule of law. When local chieftains can block mountain passes and extort steep tolls, or when highwaymen and pirates can exact their own tolls with impunity, transportation becomes risky and expensive. Conversely both transportation costs and lending risks are reduced if private property rights are respected and enforced.

Efficient capital markets foster trade by reducing transaction costs. Such markets depend on property rights and laws of exchange and on fast and reliable methods of communicating information such as prices, weather, and changing market conditions. Like transportation, communication depends on the level of technology.

Low capital costs are the result of a lot of people acting responsibly for many years: sound currency, institutions protecting private property and preserving the rule of law, inventors devising new and useful products, entrepreneurs bringing those products to market and finding ever-more-efficient ways to satisfy customers, and individuals producing more than they consume and saving for the future.

False Signals

Artificially low interest rates signal the existence of capital goods that were never actually created. While these low rates may spark investment bubbles, the bubbles must eventually burst when competition for scarcer-than-expected capital goods, services, and labor drives prices up.

Manipulating markets through monetary policy devalues a nation’s currency, destroys rather than secures property rights, and does nothing to sustain the rule of law constraining both the rulers and the ruled.

The costs of fooling ourselves can be high. By readjusting my bathroom scale I disable an indicator that might warn me when I need to change my eating and exercise habits. By overriding market money prices we similarly deny ourselves important data about the country’s fiscal health. Our weight and the real price of money are both valuable pieces of information providing vital feedback on our actions. Manipulating that feedback destroys the value of the information and, rather than giving us control, gives us only the illusion of control.

We can’t get anywhere with these questions until we agree on the meaning of inflation. At one time the word referred to an increase in the money supply. Over time it came to mean a general increase in prices, an unfortunate turn of events not just because we lost the nice metaphor of an inflating balloon, but also because the shift in meaning tended to obscure the relationship between the two phenomena. Some free-market authors hold out for the old definition, but I suggest this is wasted effort. In my classes I use the phrases “price inflation” and “money inflation” to keep the distinction alive without getting too sidetracked by semantics.

In 1970 Milton Friedman said, “[Price] inflation is always and everywhere a monetary phenomenon.” This is not entirely true but understandable because he was writing at a time when the causal relationship had nearly been forgotten. We can have price inflation without money inflation when there is a supply shock. An overthrow of the Saudi government, for example, might well disrupt the flow of oil from that country. A surging oil price, because it is so important to our economy, would likely pull up the price level with it. In this situation the monetary authorities can help things by doing exactly nothing—letting higher energy prices do the work of encouraging marginal users to cut back. Supply shocks, as such one-time events are called, do not of themselves generate sustained price increases and are therefore not classified as inflation by some economists.

Price inflation of a mild sort can also happen as new and more efficient payment systems are devised. When we acquire debit cards and credit cards, we find it less necessary to hold a supply of money for our daily needs or emergencies. We may reduce not just our currency holdings but also our checking account balances. But money is always in someone’s possession, so an aggregate decline in the demand to hold money results in faster spending, which generates price inflation. Those higher prices motivate people to increase their desired money holdings back to the previous level.

Expectations of future price inflation can also be a source of current price inflation. There is a great deal of inertia in inflation expectations. When there has been a long period of stability we tend to gloss over early signs of inflation, and it takes a long time for people to realize that price rises aren’t just temporary. Likewise, when prices have been rising steadily, people are skeptical of deflationary (or disinflationary) developments. During an inflationary period expectations can run ahead of the money supply. Thus during the German hyperinflation of the 1920s people spent their money faster than the authorities could print it, and almost until the end the authorities denied that money printing was the root of price inflation, believing instead that money creation should be stepped up.

Recently Fed Chairman Ben Bernanke said he was not worried about price inflation because investors are currently paying a very low premium for inflation-protected Treasury securities, adding, “The state of inflation expectations greatly influences actual inflation.” Gerald O’Driscoll, well known in free-market circles and a former Fed official, retorted that Bernanke “has the causation precisely backwards” (TheFreemanOnline, Feb. 28). In fact the causation runs both ways. Market participants try to figure out what the Fed will do, and the Fed tries to figure out how it can influence expectations, and on it goes, back and forth. But as in the stock market, expectations may turn out to be wrong, and in the long run only the fundamentals matter.

What of the converse of the Friedman proposition? If there is money inflation must there necessarily be price inflation? The first chart suggests not. Price inflation got ahead of money inflation in about 1980, as Fed Chairman Paul Volcker’s tight money policy did not at first overcome expectations. But since 2008 the monetary base has exploded without any significant price inflation. Why?

The Federal Reserve controls the monetary base, consisting of publicly held currency plus commercial banks’ reserve accounts at the Fed (this is also referred to as M1). The Fed increases the base when it purchases assets, typically government securities, using newly created money. Commercial banks then pyramid on top of the monetary base. A dollar of reserves can support up to about ten dollars in new loans—a multiplier effect. In the 1950s M1 was about 3.5 times the size of the monetary base. That multiplier declined sharply after 2000, until, as the first chart shows, the monetary base raced ahead of M1 money.

New money created by the Fed first goes to the bank accounts of the parties such as bond dealers from whom the Fed buys assets. Typically banks loan out most of that money because that’s how they seek profits. Bankers normally consider reserves in excess of the level required by the Fed as idle assets, which are to be avoided. Total reserves were around $2 billion until the crisis of 2008, at which time they began to skyrocket. They now exceed $1,100 billion. What motivated this huge increase? First, banks seem not to find a lot of attractive lending opportunities at this time. Second, since 2008 the Fed has been paying interest on reserves, currently a very modest 0.25 percent per year.

About Those Reserves . . .

Now for the $64 trillion question: What if banks reverse course and start deploying some of those idle reserves? Suppose they find good loan opportunities and jumpstart the pyramiding process? If the M1 money multiplier were to rebound from 0.8 to 1.6, where it stood just three years ago, assuming no change in the monetary base, we would get about $2 trillion flooding into markets. What could the Fed do to head off the price inflation that would follow?

In the past the Fed might have opted to drain reserves by selling Treasury securities. This would depress the price of those securities and raise interest rates—not good for the economy and not good for the Treasury, which counts on selling large quantities of new securities at low interest rates. The Fed now has an alternative that could restrain price inflation by keeping reserves in place. It could raise the interest it pays on reserves. This would discourage banks from expanding their loan portfolios. This latter method can be applied at a keystroke, in contrast to sales of Treasury securities, which takes time. Still, we have to wonder if Bernanke and friends will apply the brakes at just the right time. Given the dynamics of expectations and the uncertain prospects for supply shocks, it will be a difficult trick to say the least. Higher interest rates could wreak havoc on the federal budget. The President’s budget proposal for FY 2012 sees net interest payments rising from about $200 billion for FY 2011 to $928 billion for 2021. As always, the budget is based on optimistic assumptions about tax revenue growth and spending restraint. But it is also optimistic about interest rates. Higher rates could drive interest expense much higher, and because so much outstanding federal debt is of short duration, the effect might happen quickly.

Price Inflation: Mixed Signals

What of current price inflation? Is it really as low as the CPI suggests? It depends where you look. House prices are way down, and housing is part of the CPI. Homeowners are assumed to charge themselves rent, but lucky for them that charge is down. This may be scant comfort to homeowners facing increases in the prices of things they buy for cash, many of which are up.

The stock market has nearly doubled since the low of early 2009. Commodity prices have been soaring. A recent 12-month period saw increases of 31 percent in crude oil, 79 percent in wheat, 166 percent in cotton, 98 percent in rubber, 44 percent in copper, and 94 percent in silver. But natural gas prices fell 23 percent, and olive oil (extra virgin, that is) is off 12 percent. Firms that process these raw materials into retail products typically hedge their positions with futures contracts, but as those contracts expire they will begin paying more for raw materials. Some of those increases are already finding their way into retail prices.

Crude-oil prices spiked to $140 per barrel in 2008, then collapsed. But in late May they again passed $100. A disruption in supplies of Middle East oil could send the price much higher, or a return to stability could send them lower. No one knows. All we know is that crude-oil price changes make their way very quickly into retail gasoline prices. Truckers and others who are sensitive to fuel prices are adding fuel surcharges to their rates. Other effects lag further behind. Should oil remain above $100 we can certainly expect more retail price increases.

Wholesale price increases on foodstuffs have already affected retail prices. The Food and Agricultural Organization’s world Food Price Index has risen dramatically, as the second chart shows. This is becoming a crisis in poor countries, where food takes a large share of personal income. Prices are beginning to rise in the United States as well. Hershey, for example, announced a 10 percent increase across the board, citing increased raw material and transportation costs. The Agriculture Department is projecting a 5 percent price increase this year for a basket of common food items (basics, not chocolate).

What about other retail prices? Walmart CEO Bill Simon, who ought to know, recently said price inflation is “going to be serious.” The news media are full of articles about inflation. The last big U.S. inflation was in the 1970s, but should it heat up we can expect the younger generation to catch on fast—and for expectations to begin to run with or ahead of price increases.

What’s Ahead

Inflation hawks are inside the gates of the Fed. Kansas City Fed president Thomas Hoenig recently blamed the Fed’s highly accommodative policy for rapidly increasing global food prices and called for an increase in the target Fed funds interest rate to 1 percent in a “fairly short period of time.” Presidents of the Philadelphia, Richmond, and Dallas branches are also considered hawkish on inflation but are opposed by New York Fed president William C. Dudley and by Bernanke himself. Bernanke recently testified that food prices have risen in all currencies, not just the dollar, as if this exonerated the Fed. Markets, after all, are globally connected.

Could China export inflation to the United States? The Communist Party’s new five-year plan is supposed to focus on the well-being of the common folk. This would mean a reduction in the forced savings that have boosted Chinese export industries and thus higher prices for Americans.

The U.S. presidential election is next year, and the political business cycle is with us as ever. The administration, aided and abetted by the Fed, will be doing all it can to reduce unemployment before the election while keeping the lid on price inflation. On the fiscal side there will be no significant budget cuts, which nearly always have negative short-term consequences but benefits that accrue only long after the election.

We would all do well to prepare ourselves, without going overboard, for inflation. Personally, I’m bullish on cat food. Why not stock up on durable goods? Savings accounts pay nothing, and you’re going to consume the stuff anyway.

Stagflation, anyone?

This policy, known as Quantitative Easing (QE), consists of buying longer-term financial instruments, notably U.S. Treasury bonds and private mortgage-backed securities. Since the Fed engaged in one round of quantitative easing in 2008–10, the current round (announced last November, but signaled for months prior) has been labeled QE2.

QE2 is a departure from the Fed’s usual procedures, which aim primarily to affect short-term interest rates through purchases of short-term (less than a year in maturity) Treasury bonds, or T-bills. This tool of monetary policy, known as open-market operations (OMO), has largely been on the sidelines for the past two years, since the Fed drove the key short-term rate to near zero in late 2008 and has kept it there. The Fed turned to QE that year because the Great Recession was so severe. QE1 was primarily aimed at buying up MBS, many of which were considered “toxic” due to mortgages that were unlikely to be repaid. These MBS were like albatrosses around the necks of many banks, leading the Fed to try to help by taking these liabilities off their hands. Astonishingly, through $1.75 trillion of such purchases, the Fed increased the monetary base (currency plus bank reserves) by nearly 200 percent between December 2008 and March 2010.

However, rather than stimulating the economy through increased lending, much of that new money has remained idle, locked up in vaults as banks have been unwilling and often unable to lend. (Regulators in the past two years have considerably tightened lending standards, making it much more difficult to qualify for a loan, especially in these uncertain times.) Moreover, the Fed started to pay banks interest on their reserves held at the Fed. This is why the massive increase in the monetary base has not brought about much increase in the active money supply (currency plus deposits), which is necessary to stimulate the economy. This is also why the official inflation rate has continued to stay so low.

Given the failure of QE1 to return growth and unemployment rates to normal levels, the Fed has embarked on another round. In early November it announced it aims to purchase $600 billion in long-term Treasuries to bring down their yields (which act as the benchmark for many long-term interest rates) and spur lending, especially in the hard-hit real-estate markets, as well as increase inflation, which, according to the Fed, is too low to be consistent with a robust rate of growth.

The announcement of QE2 was received with widespread skepticism or even outright derision— from distinguished monetary economists such as John Taylor as well as politicians like Sarah Palin. Chairman Ben Bernanke and the Fed governors have, in return, mounted a major defense, with Bernanke even appearing on 60 Minutes in early December. But his protestations ring hollow. Every Fed chairman has sworn that he was not to blame for the economic calamities that occurred on his watch, and that without his actions things would have been much worse. It is always only years later that subsequent Fed policymakers are willing to acknowledge the Fed’s previous failures.

Inflation Expectations

The critics of QE2 have pointed to two problems with the policy: First, the Fed is seemingly ignoring the key role that inflationary expectations play in its ability to effect a macroeconomic result. The Fed’s actions are reminiscent of the 1960s, when the Keynesian economic mainstream relied on the now-discredited Phillips Curve theory to control the economy. The Phillips Curve purported to show a stable trade-off between inflation and unemployment; therefore the policymakers needed only to increase inflation to lower unemployment to an acceptable level. It turned out that this only worked as long as people’s inflationary expectations did not change—but of course as inflation went up, inflation expectations followed, ultimately leading to increasing rather than decreasing unemployment. After the painful stagflation of the 1970s, as well as the theory’s thorough drubbing by some of the most highly respected economists of the past half a century (including Milton Friedman), one would have expected the Fed to have permanently learned how difficult it is to control inflation expectations, as well as how fundamental they are to the Fed’s ability to control inflation itself. However, the Fed now appears committed to taking us down that road again. (And in fact Treasury yields went up rather than down in the first six weeks of QE2, possibly due to inflation expectations—a key component of long-term interest rates—themselves going up).

If the Fed Had a Hammer

The second problem with QE2 is that the Fed is stuck in an inappropriate economic model, which embodies the adage that when all you have is a hammer, every problem looks like a nail. The Fed really only has one policy tool: raising and lowering interest rates, whether short- or long-term. Therefore all economic problems seem solvable to the Fed through the use of this tool. The Fed has used it enthusiastically over the past ten years, bringing interest rates down to then-record levels in 2003–05, spurring a massive boom in both private and public debt and pushing the average savings rate negative for the first time in U.S. history. It is now increasingly accepted that loose monetary policy was one of the major causes—maybe even the primary one—of the Great Recession. For the past two years individuals and businesses have been slashing expenditures, increasing savings, and paying down debt—trying to get through the Keynesian hangover. But the Fed will have none of that: If Americans are not borrowing and spending enough, the Fed will lower not only the short-term rates but also long-term rates. In other words, it’ll make us an offer we can’t refuse—and we’ll be back on that not-so-merry-go-round yet again.

In response to these and other criticisms (leveled even by some of the Fed’s own, such as Kansas City Fed president Thomas Hoenig), Bernanke and other Fed officials responded in an unexpected way: They claimed the current policy isn’t actually “quantitative easing,” since the money used to purchase the Treasuries will not be newly created and therefore the monetary base will not increase. With QE1 the Fed “printed money” to purchase the assets, but this time it is simply “reinvesting” the funds that it receives from the maturing MBS in its portfolio.

This is a rather strange turn of events, as the Fed itself initially emphasized the $600 billion, making it appear that this will be a new injection and therefore a stimulus. But if the monetary base stays the same, it means only that the Fed is changing the composition of its balance sheet: fewer MBS, more Treasuries. That may have some macroeconomic effect (currently debated in the blogosphere), but certainly not very much, either on unemployment or inflation. Yet Bernanke and others have made a big deal about QE2 lowering long-term interest rates, stimulating the economy, lowering unemployment, and diminishing the danger of a deflationary spiral, something that they cannot possibly believe if QE2 isn’t really a quantitative easing.

So what exactly is going on here?

It is difficult to know. Economists are increasingly noticing the inconsistencies between the Fed’s words and deeds, but so far it has led mostly to head scratching. A likely explanation is that the Fed is trying to fool us—to convince us that there is an ongoing monetary stimulus, hoping that this will comfort investors and real-estate markets, while simultaneously reassuring inflation hawks that the policy will not further increase the monetary base, which has already gone up quite enough. If this conjecture turns out to be right, a notable victim of QE2 will be Bernanke’s commitment to his own ideals. He has been a leading proponent of inflation targeting, which stresses the importance of continuous and thorough communication with the public for the sake of transparency and accountability. All that appears to be out the window now. Not only is the Fed failing to be transparent, it may be guilty of actively misleading us. After three decades of increasing transparency, it seems that the Fed may be returning to its old ways.

It might be difficult to accept that the Fed would be willing to risk its hard-won credibility just to get some more short-term stimulus. Yet it is possible that this is all driven by a much bigger issue: U.S. fiscal policy, which has gone over the cliff in the past three years. The federal government has racked up $5 trillion in new debt in that time, with much more to come, financed through new Treasuries. Such a massive increase in supply has been driving down their price and pushing up yields—along with long-term interest rates. Given the extremely fragile real-estate market, rising long-term interest rates are the last thing the Fed wants, so it is not surprising that it would attempt to counteract them.

More problematically, the Fed may also be buying up Treasuries to keep down the financing costs of the federal government’s growing debt burden. If this is indeed what has been driving QE2—which the Fed, not surprisingly, vehemently denies—it would mark a sharp break with modern history. In the Accord of 1951, the Fed reasserted its control over monetary policy after ten years of pegging bond rates very low to make it cheaper for the federal government to fight World War II. If it begins to be perceived as the Treasury’s puppet again, investors could rapidly lose confidence in the prospect of both an economic recovery and low inflation, not to mention the long-term viability of the massive federal government debt.

Eventually the economy will start growing faster, likely leading to a rapid dislodging of currently idle reserves through cheap loans. As that cash starts entering the economy, inflation rates will inevitably be driven higher. The Fed may or may not keep this process under control, but it doesn’t even matter all that much, as the damage will already have been done. What Bernanke and most others at the Fed clearly fail to understand is Ludwig von Mises’s and F. A. Hayek’s fundamental point that artificial manipulation of interest rates by a central bank distorts microeconomic reality, perverting relative prices and sending the wrong signals to both entrepreneurs and consumers. This leads to faulty decision-making, resulting in more misallocations, malinvestments, and asset bubbles. In other words, by not allowing prices to fall to correct for the past artificial stimuli, the Fed is actually preventing the economy from adjusting and beginning a true recovery. QE2 continues this error.

There is always an easy solution to every human problem – neat, plausible, and wrong. –H. L. Mencken

I have devised a simple plan for improving Americans’ health by drastically reducing everyone’s weight, significantly increasing longevity and reducing medical costs.  All we need to do is revalue the pound.  Instead of a pound being 16 ounces, it will now be 32, cutting everyone’s weight in half.  We adjust our bathroom scales, our weight drops, and our health is improved.

Of course this “solution” rests on two fallacies.  First, it conflates measurement with what is measured.  Adjusting my bathroom scale does not change my weight, only my perception of my weight.

Second, the solution confuses cause and effect.  My weight is not necessarily the cause of my health or lack thereof; in fact, my weight may be caused by my health – an injury that keeps me from exercising or a thyroid condition, for example.  More commonly, good health is the result of responsible actions taken over many years: moderating calorie and alcohol intake, eating the right foods, engaging in regular exercise, getting quality dental and medical care.  Such actions are likely to result in both moderate weight and good health.  Conversely, I can no more make myself healthy by adjusting my bathroom scales than a doctor can cure a child’s cold by adjusting the thermometer he uses to measure her fever.

Brilliant Fools

The two fallacies are so obvious that no one could possibly fall for them, right?  Sadly, no.  Many brilliant people have fervently believed in nearly identical fallacies for decades and are even now basing our country’s monetary policy on them.

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760 – 1830 (9-10):

If we seek – it would be wrong to do so – for a single reason why the pace of economic development quickened about the middle of the eighteenth century, it is to low interest rates we must look.  The deep mines, solidly built factories, well-constructed canals, and the houses of the Industrial Revolution were the productions of relatively cheap capital.

John Maynard Keynes, making this same observation years before, concluded that simply by manipulating a country’s monetary supply and financial markets to produce artificially low interest rates, “deep mines, solidly built factories, well-constructed canals and houses” would spring into being.  But Keynes is confusing “cheap capital” with easy money.  Capital – inventories, pre-consumer goods, and the methods and means of production – cannot be conjured into being by manipulating interest rates.  They must be produced through saving, that is, deferred consumption.

Capital goods can be relatively cheap only if they are relatively plentiful.  Increasing capital, all else equal, will lower interest rates.  Interest rates are a measure of capital’s availability. Dictating low rates will not improve a nation’s fiscal health any more than manipulating my bathroom scale will improve my physical health.

But low interest rates depend on more than just the availability of capital goods.  They are also a function of the risk in lending.  Risk in turn can be affected by such things as the reliability and efficiency of transportation, communication, and capital markets.

Transporting goods by human or animal power is slow and costly.  Sailing ships can carry far more goods far more quickly.  Steam-powered ships are faster and more efficient still.  Transportation costs, then, are inversely proportional to the level of technology.  But costs also depend on the rule of law.  When local barons can block mountain passes and extort steep tolls, or when highwaymen and pirates can exact their own tolls with impunity, transportation becomes risky and expensive.  Conversely, both transportation costs and lending risks are reduced if private property rights are respected and enforced.

Efficient capital markets foster trade by reducing transaction costs.  Such markets depend on property rights and laws of exchange and on fast and reliable methods of communicating information such as prices, weather, and changing market conditions.  Like transportation, communication depends on the level of technology.

Doing the Right Thing

Low capital costs are the result of a lot of people doing the right things for a lot of years: institutions protecting private property and preserving the rule of law, inventors devising new and useful products, entrepreneurs bringing those products to market and finding ever more efficient ways to satisfy customers, individuals producing more than they consume and saving for the future.

Artificially driving interest rates down cannot raise a nation’s level of technology, magically bringing railroads or fax machines into being.  Manipulating markets through monetary policy destroys rather than secures property rights and does nothing to establish rules of law that constrain both the rulers and the ruled.

The costs of fooling ourselves can be high.  By readjusting my bathroom scale I disable an indicator that might warn me when I need to change my eating and exercise habits.  By overriding market money prices we similarly deny ourselves important data about the country’s fiscal health.  Our weight and the real price of money are both valuable pieces of information providing vital feedback on our actions.  Manipulating that feedback destroys the value of the information and, rather than giving us control, gives us only the illusion of control.

Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined. Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods. With ever-changing populations, technology, and preferences, markets are turbulent, and fluctuating human desires and costs cannot be accurately predicted.

The quantity of money in the economy is like that of other goods. The optimal amount can only be discovered by the dynamics of supply and demand. The impact of money on prices depends not just on the amount of money but also on its velocity—that is, how fast the money turns over. The Fed cannot control this since it cannot control the amount people want to hold, or the demand. Also, even if the Fed could determine the best amount of money for today, the impact of its moves takes months to play out, so the central bankers would need to be able to accurately predict the state of the economy months into the future.

The Fed also fails because of political pressure. Although the Fed is supposed to be independent, in practice, when the economy is depressed, there is strong political pressure to “do something,” specifically to “stimulate” by expanding the money supply. Since Congress created the Fed and can alter it, it is impossible for the Fed to be purely independent of politics.

The Federal Reserve was set up to provide price stability, yet the United States suffered high inflation during the 1970s and continuous inflation since World War II. The Fed was also supposed to provide economic stability, but since World War II there have been severe recessions in 1973, 1980, 1990, and 2007–2009. The Fed was supposed to ensure stability in the financial system, but it failed to prevent the Crash of 2008 and the Great Recession that followed. But the challenge is to explain why free banking would be better.

Suppose gold once again became a global currency. It would be the real money, and the U.S. dollar would be defined as a particular weight of gold. A $20 gold coin had about an ounce of gold before 1933.

Under free banking most transactions would not occur with gold, but rather with more convenient money substitutes. Banks would issue paper bank notes inscribed with their bank names. Anyone holding bank notes could exchange them for gold. For example, if $1,000 was equivalent to an ounce of gold, then anyone could go to a bank and convert $1,000 in paper bills to one ounce of gold coins. Likewise one could withdraw $1,000 of deposits in gold coins.

Competition among banks, as well as convertibility into gold, would result in price stability, since the banks would only be able to issue as many bank notes as the public was willing to hold. If there were more bank notes than that, they would come back to the bank to be exchanged for gold. But the money supply would also be flexible, since if there were a greater demand to hold money, the amount of bank notes or bank deposits would increase.

The Structure of Capital Goods

Free banking mitigates the boom-bust cycle. There is a structure to capital goods similar to a stack of pancakes. At the bottom of the stack are rapidly circulating capital goods such as inventory close to the consumer-goods level. As we go up the stack, the capital goods turn over more slowly. At the top are long-duration investments such as real-estate development. Goods become more sensitive to interest rates as you move up the stack. Lower interest rates make the stack steeper, as there is more investment in long-term investments.

In a free market the “natural rate” of interest depends on the preference for goods sooner rather than later, or “time preference.” Interest is the premium paid to shift purchases from the future, for which one would have to save enough to pay cash, to the present day by borrowing.

The Fed lowers the rate of interest by creating fiat money out of nothing. As a result, businesspeople borrow more for capital goods high on the stack, such as real estate. Prices rise fastest and soonest where the money is being injected into the economy with loans. Thus real-estate prices escalate, creating a bubble like those that occurred before 1973, 1980, 1990, and 2007; indeed a similar bubble occurred during the 1920s before the Great Depression.

Every boom preceding a bust has been fueled by artificially cheap credit. With free banking the interest rate would not be manipulated down. The natural rate of interest would raise the carrying cost of borrowed funds, reducing if not preventing the financial fever.

Further Reforms

Free banking is not a panacea: There need to be other reforms to achieve sustainable economic growth. Punitive taxes, subsidies, and arbitrary restrictions all distort the economy, stifle enterprise, and create turbulence. But even without such other reforms, the case for replacing central banking with free banking is strong, resting on three facts:

1. The optimal money supply and interest rates are unknowable in advance, and can only be discovered by market dynamics.

2. Political pressure makes the Fed expand the money supply and reduce interest rates when the economy is depressed, and this fuels an unsustainable boom that results in the next bust.

3. Government insurance, guarantees, the expectation of bailouts, and other subsidies induce excessive risk-taking, making financial crashes worse.

Cowen states that if the Fed were to shut down, the new base money would be Treasury bills. (Base money currently consists of money in circulation, bank vault cash, and commercial bank reserves on account at the Fed.) But folks don’t buy groceries with Treasury bills. The best transition base money would be the current amount of Federal Reserve notes, whose supply would be frozen, as suggested by Professor George Selgin. Then new-money expansion would be the money substitutes issued by the banks, convertible into base money. Eventually, with the abolition of legal-tender laws, world financial markets would converge on a common global currency, gold.

The case for free banking is similar to the case for healthy living. It is better to prevent economic illness than to have to treat it.

Yet some data and sound theory, which take into account more than simple macroeconomic aggregates—higher GDP good, lower GDP bad—indicate that the U.S. economy has not fully recovered. The official unemployment rate is still over 9 percent, private long-term investment remains at low levels, and even GDP growth has been weak, in spite of the great increase in government spending for final goods and services (which adds directly to GDP, defined as consumption plus investment plus government spending plus net exports).

The weak recovery is clearly recognized by policy-makers, who have advocated and implemented additional fiscal and monetary stimulus by the Obama administration and perhaps the Federal Reserve. They seem to take for granted that an unexpectedly slow recovery requires even more expansionary government policies to keep the economy on track.

The slow recovery from the recession presents an analytical challenge, provoking debate among macroeconomists and pundits. As usual, there are many diverse explanations, some complementary, some contradictory. To an important extent these divergences reflect different conceptions of the business cycle. I will describe and briefly analyze four of the most common explanations.

The Keynesian Story

Let us start with the Keynesian story, filtered through the writings of Paul Krugman. (There are much more nuanced versions of Keynesianism than Krugman’s.) In his weekly column and popular blog at the New York Times, Krugman declares that the slow recovery and the persistence of high unemployment arise from a “lack of aggregate demand,” which is the main cause of the poor sales by private businesses and hence of the high unemployment rate.

In his characteristic self-confident argumentative style, Krugman asserts, “Businesses aren’t hiring because of poor sales, period, end of story.” This sentence is followed by a graph showing a substantial increase since late 2008 in the percentage of small businesses that named “poor sales” as their “single most important problem.” The remedy for this malaise is, of course, more public spending: “[T]he best thing government could do to help business would be to spend more, increasing demand.”

However, as many economists have written in recent years, Krugman’s focus on aggregate demand is simplistic, to say the least. First, one needs to ask, why is the growth of aggregate demand so weak? It may very well be that spending less and saving more is a healthy reaction to the previous unsustainable boom. Thus weak demand might be an inevitable consequence, not the deep cause, of the current bust.

Furthermore, what particular parts of the economy—which markets or industries—suffer most from low sales? As Austrian economists argue, we need to disaggregate the macroeconomic picture to understand what is going on. Nevertheless, such disaggregated analysis does not seem to be important for some Keynesians, such as Krugman and Brad DeLong. In November 2009, DeLong wrote, “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test—anything at all.”

The Monetarist Story

The monetarist story of Milton Friedman’s followers is usually presented as the free-market alternative to the Keynesian interpretation. However, these explanations have important though subtle points in common.

In simple terms the monetarist thesis focuses mainly on sudden bank credit contraction. Monetarists argue that the accumulation of vast amounts of excess reserves by banks—which basically means that instead of lending money to the private sector, they are keeping it to themselves—has negative effects for the whole economy. Given that credit is usually considered the economic equivalent to the human body’s blood circulation, a credit contraction is seen as invariably dangerous. If a person suffers a sudden loss of blood, the cure would be to inject blood into him. The same cure applies to credit, the monetarists claim.

Economists from this perspective usually refer to how the velocity of money—the average frequency with which a unit of money is spent in a specific period—collapsed in the second half of 2008. To compensate for this reduction, monetarists recommend an expansionary monetary policy by the central bank.

Although one might think that Fed Chairman Ben Bernanke’s strategy has been to respond precisely in this way, some economists, such as Scott Sumner, argue otherwise. Sumner claims the Fed’s monetary policy since the end of 2008 has actually been contractionary relative to what the economy needed at that time. Bernanke should have been more aggressive, Sumner argues, to avoid the contraction of nominal GDP that finally occurred.

This explanation suffers from several problems, similar to the shortcomings of the Keynesian story: (1) excessive aggregation of key concepts—making extensive use of GDP as the key indicator of the cycle does not allow the monetarists to explain the crux of the matter, which is the real microeconomic distortions in the productive structure of the economy that had been created during the boom; (2) the analysis of the crisis and the sharp credit contraction as exogenous shocks, rather than consequences of the previous unsustainable credit expansion. From Sumner’s point of view, it seems that the fall in nominal GDP was something to be avoided.

The Austrian Story: The Adjustment Problem

For economists drawing on the Austrian story, GDP contraction was a symptom of the bust, the inevitable hangover after a credit spree that led to bad decisions—malinvestments and excessive leverage. As the Austrian business cycle theory emphasizes, the economy has to go through a process of adjustment that cleanses the massive errors resulting from economic decisions taken in the past. This restructuring involves not only reallocating factors of production (capital and labor), but also reducing debt a significant amount (deleveraging), which has contractionary effects on demand and aggregate economic activity.

This consideration leads to the first element of the best explanation for the prolongation of the recession: the fact that the necessary adjustment process has not been completed. As a recent report by the Bank for International Settlements (BIS) concludes, the debt reduction of private economic agents still has a long way to go. But as the Spanish economist J. R. Rallo argues, keeping interest rates extremely low for a prolonged period, as the Federal Reserve has, creates incentives for people not to reduce debt and adjust to the new circumstances. Moreover, government “stimulus” policies may have made things worse by massively increasing federal government debt.

Furthermore, the necessary reallocation of the factors of production—both intersectoral (from sectors overexpanded during the bubble to sectors that will yield higher profits in the future) and intrasectoral (among different products and services in the same sector) may take a long time, especially in the labor markets. Apart from the fact that the adjustment in relative prices and wages may take longer than desirable because of rigidities, there are additional issues worth considering.

Research on markets with search frictions—which won Peter Diamond, Dale Mortensen, and Christopher Pissarides the 2010 Nobel prize in economics—may fit in this context. For several decades mainstream neoclassical economists have depicted the market as a mechanism that perfectly and instantaneously coordinates supply and demand. The Nobel laureates, however, have emphasized that economic agents often have to spend time and resources in making that adjustment (search frictions). Moreover, finding satisfactory employment for people who have just lost jobs may require the acquisition of substantially different skills and capabilities. The features of this process depend on the degree of specificity and complexity of the economy’s capital structure. Thus not only physical capital but also human capital has to go through an adjustment process. All this takes time.

Regime Uncertainty

The second main piece of the puzzle of the recession’s duration is the “regime uncertainty” argument formulated by Robert Higgs. He first elaborated this concept to explain why the Great Depression lasted so long, finding that the Roosevelt administration, with its constant attacks (in rhetoric and in policies) on the free-enterprise system and its threats to private property, was largely responsible for the failure of long-term private investment to recover fully until World War II ended.

Not surprisingly, in a series of commentaries since 2008, Higgs has found parallels in the Obama administration’s actions and in the stagnant private investment that help to explain why sustained economic recovery has not yet taken place.

Higgs points to several particular causes: the surge in the federal deficit and debt; the likely introduction of new taxes to finance the recent massive public spending, or changes in existing tax rules; the potential burdens on businesses brought about by environmental and energy regulations; and the still uncertain real effects of Obamacare and the new financial regulatory framework.

Problems related to the adjustment process, along with the existence of regime uncertainty, might form a relatively complete explanation of why the U.S. economy is still suffering from the Great Recession, complementing the analysis expressed in the Mises/Hayek business cycle theory.

The importance of this debate, and how current economic events are interpreted, can hardly be exaggerated. As economist Mario Rizzo has noted, the resolution of this puzzle “will affect economics and public perceptions for a long time to come,” just as the debate between Hayek and Keynes in the 1930s had profound (and unfortunate) consequences for the future of the economics discipline. Let us hope that the outcome will be different this time.

Economists are prone to write turgid prose and employ a jargon-filled style. Not these two gems. Each author is a deservedly well-regarded economist, eminent in his field, but their books are written for the layman. Both draw on detailed academic research, but neither requires the reader to wade through thickets of citations.

Taylor poses these questions: “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began?” His answer in each case is first and foremost “specific government actions and interventions.” The heart of his argument is a criticism of Fed monetary policy under Alan Greenspan in the aftermath of the collapse of the dot-com bubble. The Fed cut interest rates and continued cutting aggressively, taking the short-term interest rate under its control (the federal funds rate) down to 1 percent. The rate stayed at 1 percent for a year. Other market interest rates fell as well. The artificially low cost of borrowing fueled the housing boom.

Taylor uses a figure to compare housing starts as they actually occurred in the boom with a counterfactual simulation—as they would have occurred had the Fed adhered to policies that began in the early 1980s and continued into the 1990s. The result: “No Boom, No Bust” in housing. Not everyone agrees that monetary policy was so benign throughout the period dubbed the “Great Moderation.” But the Fed’s cheap money policy after 2000–01 brought back volatility in housing and the economy last seen in the 1970s.

Taylor explains how the Fed exported its easy money to other countries (especially the European Union), drawing them into the crisis. He also examines the many other complications, including such issues as the actions of Fannie Mae and Freddie Mac, and the role of securitization. His analysis of the many policy missteps in response to the crisis is masterful. These policy errors prolonged the crisis.

While Taylor covers a broad array of issues, focusing particularly on monetary policy, Sowell focuses
on the housing market itself, chronicling the “skyrocketing rise” in home prices. From 2000 to 2005 the median sales price of a single-family home rose 53 percent, from $143,600 to $219,600. In the priciest markets, like New York City, Los Angeles, and San Diego, prices escalated at an even more rapid rate (79, 110, and 127 percent, respectively). How could home prices have increased so much in such a short period, then fallen so fast?

Sowell also asks the commonsense questions. “When it comes to the home mortgage boom and bust, who was to blame? The borrowers? The lenders? The government? The financial markets?” He answers yes to all the above and notes that “economics cannot explain such things.” Politics drove the housing boom, and he turns to the politics.

First, there is the wonderfully misnamed policy of “affordable housing.” Never precisely defined, it is
a complex combination of misguided policies. They include policies to lower borrowing costs, down payments, lending standards, and, generally, costs of homeownership. Instead they have together combined to increase housing costs. As Sowell observes, it is precisely where government intervention in housing is the greatest that housing costs are highest.

Government housing policies have been at war with themselves. Sowell cites the case of housing in coastal California, now one of the highest-priced markets in the country. As late as 1969, however, home prices there were affordable by a number of measures and in line with home prices in the rest of the nation. In the 1970s California began introducing land-use restrictions that drove up costs for lots and their development. He examines alternative explanations for the rapid escalation in prices and concludes it was the land-use policies that were responsible for astronomical housing costs in coastal California.

California’s land and housing policies were extreme, but not unique. So we have longstanding policies restricting the supply of land and homes meeting policies to stimulate demand. When demand is stimulated and supply restricted, prices will necessarily increase. Land-use restrictions, affordable housing, and easy credit caused the housing boom and bust.

For the full story, I recommend these two estimable books to Freeman readers.