## Thursday, October 02, 2008

### The Price of Money and Other Errors

It is common for people who think they understand economics to describe the interest rate as the price of money. If it were true, then printing more money would lead to lower interest rates, and many of the same people think it does.

The next time someone tells you that the interest rate is the price of money, ask him what he thinks a reasonable interest rate is and offer to buy some money from him—at ten cents on the dollar if the rate he suggests is ten percent. As that example illustrates, the interest rate is not the price of money. The price of money is what you must give up to get it. If apples cost fifty cents each, the price of money is two apples. More generally, the price of money is the inverse of the price level—when prices are high, that means that money is not worth very much.

The interest rate is the rent of money measured in money. Suppose you borrow a hundred dollars at ten percent. If the price of a dollar is two apples, you are borrowing the price of two hundred apples and paying the price of twenty apples a year in interest. If the money supply doubles, prices double, including the price of an apple, you are borrowing the price of a hundred apples and paying the price of ten apples a year in interest. If you prefer, you could do the same real transaction as before by borrowing two hundred dollars and paying twenty dollars a year interest, still at ten percent.

As this example suggests, there is no connection between the amount of money in circulation and the interest rate. There is a connection between the rate of change of the amount of money in circulation and the interest rate, but it goes in the opposite of the direction implied by the error I am discussing. When the money supply is increasing and prices are rising, nominal interest rates are high, not low, because lenders must be compensated for the fact that they will be paid back in dollars worth less than the ones they lent.

Much of the confusion here comes from the multiple meanings of the term "money." When we say someone has lots of money, we don't usually mean that he has a lot of green paper or a large balance in his checking account; we mean that he is wealthy. His wealth might be in money, it might be in valuable real estate, it might be in stocks and bonds. If there is lots of money in that sense—more precisely, if lots of people have wealth they would like to lend out—that will tend to lower interest rates. But that has nothing to do with the amount of money in circulation.

What brings up this particular confusion at the moment is the attempt to link the current crisis with the events that led to the Great Depression. Those events produced a sharp drop in the money supply, due to banks going broke and depositors either losing or withdrawing their deposits. Given the nature of a fractional reserve system, replacing a mix of currency and deposits with just currency reduces the total amount of money in circulation, in that case by a lot. The problem could have been prevented if the Federal Reserve System had kept those banks from failing, which was part of the purpose it had been set up for, a purpose that had been served earlier by the private arrangements among banks that it effectively replaced.

That series of events cannot happen now because the FDIC insures bank deposits. What we are observing is not a drop in the money supply. It is a loss of wealth, as firms discover that their assets, in particular mortgages and securities backed by mortgages, are worth less than they thought. That explains why the proposed bailout is enormously greater than would be required to prevent a run on bank deposits. \$700 billion is roughly half the total money supply of the U.S. (M1—currency plus checking accounts and similar assets)--and about half of that is currency, which isn't going to vanish whatever happens to the banks. The total wealth of the economy is enormously greater than the total amount of money in the economy, and the bailout is a response not to a reduction in the amount of money but a reduction in the amount of wealth.

That also explains why the bailout has very little to do with preventing another Great Depression. The U.S. money supply at the moment is at or near its all time high, and it is hard to see how anything likely to happen, with or without a bailout, will reduce it by much. The mechanism that set off the Great Depression isn't happening.

What is happening is the failure of lots of firms. The failure of a firm doesn't wipe out wealth, except to the extent that the firm itself—its firm culture, web of relationships and such—has some value. When a firm fails, that is at least some evidence that that value was negative, which is why nobody chose to buy out the firm and keep it going. The ordinary assets of the firm—its buildings, land, stocks, bonds, mortgages, and whatever it owns—don't vanish when the firm fails, they get sold to someone else.

The bailout is not a way of preventing the loss of value. The loss (or transfer) of value occurred when people made bad mortgage loans. What happened more recently was the recognition of that loss. All the bailout can do is to shift the loss from some people to others, from the stockholders and creditors of firms that are now effectively bankrupt to the taxpayers.

All of which comes back to confusion over the meaning of "money."

At 2:14 PM, October 02, 2008,  Michael F. Martin said...

I mostly agree with you here. So what if the entire financial industry ends up consolidating into the handful of firms that didn't get as deep into the subprime market?

But at some point the engine of the economy actually stops turning over. When treasuries are actually selling for negative interest rates, that's a pretty good indication that the economy has completely stalled.

If the Fed can restore a sense of security by investing in assets selling at cents on the dollar, then it makes sense to go ahead and buy.

A separate question is whether distinctions between public and private make sense anymore given the fact that it's the same people coming and going between the two sets of institutions in these markets?

At 2:30 PM, October 02, 2008,  hodja said...

I agree with everything except the last statement. The cost is going (mostly) not to taxpayers but to all dollar holders, whose money is being inflated. A significant part of whom are outside of the United States.

At 2:43 PM, October 02, 2008,  Arthur B. said...

When the money supply is increasing and prices are rising, nominal interest rates are high, not low, because lenders must be compensated for the fact that they will be paid back in dollars worth less than the ones they lent.

Do you take into account the role of banks ? No matter the expectation of inflation, the long term interest rate is bounded by the arbitrage consisting in financing long term loans with short term deposits. This is uncertain because the central bank may change the short term rate, but still.

In this case, isn't the rise of long term interest rate when inflation rises simply reflecting the expectation that the central bank will eventually tighten to fight the inflation ?

Also, imagine an economy using gold and an alchemist who produces gold in his cellar. Do you disagree with the idea that - at first at least -his activities will lower the interest rate ?

Conversely do you disagree that all else equal a rate cut increases the monetary mass ?

At 3:00 PM, October 02, 2008,  David Friedman said...

"In this case, isn't the rise of long term interest rate when inflation rises simply reflecting the expectation that the central bank will eventually tighten to fight the inflation ?"

No. It would happen--does happen--even when the expectation is that the inflation will continue for a long time. In equilibrium, in a fully informed economy, the effect is simply to raise the nominal interest rate by the inflation rate, leaving the real interest rate unaffected.

"Also, imagine an economy using gold and an alchemist who produces gold in his cellar. Do you disagree with the idea that - at first at least -his activities will lower the interest rate ?"

Yes I disagree. The effect on the interest rate will depend on how he spends his gold. If he uses it to make loans, he is in effect taxing all holders of gold and using the money to lend out, which lowers interest rates. If he spends the money on cavair, on the other hand, the effect is to raise the price of caviar.

At 3:44 PM, October 02, 2008,  Arthur B. said...

No. It would happen--does happen--even when the expectation is that the inflation will continue for a long time. In equilibrium, in a fully informed economy, the effect is simply to raise the nominal interest rate by the inflation rate, leaving the real interest rate unaffected.

Why would anyone get a long term loan at a high rate rather than roll a short term loan at a lower rate ? Risk of course is a valid reason but I don't see it connected to inflation.

The effect on the interest rate will depend on how he spends his gold.

It also depends how the caviar seller spends his loan and so on. But down the chain it is certainly possible than some people will loan the money. What happens to interest rate would depend on when that happens.

In the special case of as single bank in the business of buying debt who who prints money, would you agree that this inflation would lead to lower rates ?

At 4:31 PM, October 02, 2008,  Anonymous said...

"All the bailout can do is to shift the loss from some people to others, from the stockholders and creditors of firms that are now effectively bankrupt to the taxpayers."

Theoretically, if the government simply bought corporate bonds (not favoring any particular firms) on the open market, the effect would be to transfer risk rather than losses. The corporate borrowing rate would go down and the government borrowing rate would go up - possibly having a stimulative effect?

At 5:05 PM, October 02, 2008,  Seven Star Hand said...

Hi David,

One must understand the truth before any true solution is possible. The truth about money is that the whole concept is a great deception that must end before there is any true justice on this planet. That is the meaning of "money." Consequently, there's much more to this unfolding story than meets the eye. Be a little patient with me and my writing to understand the hidden truth and then hold their feet to the fire!

Money Karma comes home to roost !!!

This is the long awaited opportunity to finally "kill the beast" and kick all the bums out, forever. Read what I have been saying for insights into another way to manage this civilization, without money and without evil cabals running this world. The keys to a "New Earth" are wisdom and cooperation, not the fears and follies of the past.

It will soon become painfully obvious, to even the most clueless, that it will be far easier to step away from the deceptions of the past (money, religion, and politics) and finally fix our civilization so it works for everyone, not just for a self-chosen and abominably greedy few. Why should humanity struggle and suffer any longer to repay massive debts and endure great debacles created by amazingly greedy and deceptive monetary and political leaders? Are you familiar with the ancient concept of a Jubilee? It's time has come, and the power of the rich and arrogant is about to be blown away on the winds of long-overdue and irresistible change.

Here is Wisdom...

Peace...

At 8:29 PM, October 02, 2008,  Anonymous said...

I'm kind of crowbarring this interview in but I was wondering what you think your dad's take would be on the current financial "crisis". Do you think he would be more sympathetic to the Austrian view? I found this fascinating inverview with Roger Garrison about your dad's views compared with Austrian business cycle theory:

AEN: At the same time, you are very
critical of, for example, Friedman for having no theory of causation.

GARRISON: In his “plucking model”
of the business cycle he just looks at the Keynesian-based National Income Statistics and describes what he sees as a revealing pattern they follow over time. But this pattern is based upon such a high level of aggregation, it is impossible to make any sense of it without a theory that operates on a lower level of aggregation. That’s what the Austrian theory does. I’ve had
correspondence with Friedman on
this issue. Not surprisingly, he
remains unreceptive to the Austrian
view. That doesn’t mean that we can’t learn from him. James Tobin once said that the best empirical evidence you can muster for your own theory is that which is discovered by your adversary. Now, here’s a prime case of that. Friedman looked at data for a
period in the 1970s when real interest rates were particularly high on the eve of a downturn. That was his empirical observation. His interpretation of the data, given in an interview
published in Barron’s, was very much an Austrian one: he attributed
the high rates just before the actual downturn to “distress borrowing.” Friedman explained that businessmen regretted having initiated investment projects during an earlier period of low interest rates but then found themselves having to borrow more to complete those projects despite the fact that interest rates had risen. That particular sequence of events, of course, is precisely the Austrian theory of the business cycle. Noticing this, I wrote Friedman, asking him if he had worked out this argument more extensively in some of his published works. He said that he had not, and, moreover, he had only intended that explanation to apply to that particular cycle. All the Austrians are saying is that this phenomenon of “distress borrowing” is more generally applicable and characteristic of credit-driven expansions.

AEN: Why didn’t Friedman recognize
his theory as Austrian?

GARRISON: Because Friedman has
never seen the significance of
Hayek’s Prices and Production. In
personal conversation he has offered this book along with Dennis Robertson’s Banking Policy and the Price Level (1932) as examples of books that are virtually impossible to understand. But if you do understand Hayek, you see that he is explaining how policy can set the market process off on a wrong course and how subsequent “distress borrowing” characterizes the particular phase of the process just before market forces win out over the effects of credit manipulation. Why does the mainstream have such a difficult time understanding the message? Because they don’t do capital theory. Especially those trained in the Chicago tradition. They all learned from Frank Knight that they didn’t have to pay attention to capital and so they ignore it. They have always considered it irrelevant to macroeconomics. They think of capital theory as the relationship between stocks and flows. If that is all that capital is, merely a formal dimensional distinction between “the stock of it” and “the flow from it,” then capital doesn’t have much to do with macroeconomics. There’s little scope for disequilibrium. For a very different set of reasons, Keynes, too, threw capital theory
out of macroeconomics. Keynes himself acknowledges this in his1937 summing-up article. He was proud to have found a way to break macro loose from all the thorny issues of capital theory. When Friedman launched a counterrevolution against Keynes years later, one point he never attacked was the throwing of capital out of macro. That was acceptable to him, due to the influence of Frank Knight.

AEN: And that’s why you claim that
Friedman is himself a Keynesian.

GARRISON: Friedman himself said
so, and the reason is that he bought into the Keynesian framework of a macroeconomic theory that made no reference to the structure of capital. In a New York Times article last year, Friedman expressed some regrets about setting out monetarist ideas in a Keynesian ISLM framework.1 He said it was a strategic mistake. Over the years, the differences between Keynesianism and monetarism
devolved into a dispute about elasticities and the shapes of curves, and the relative djustment speeds of prices and wages. Not that Friedman now thinks he would have been better off expressing monetarist ideas in a Hayekian framework. He simply thinks that there is a more fundamental distinction between his views and Keynes’s: monetarists believe markets work and the Keynesians believe they don’t. But to demonstrate exactly how markets work is where you need a theory of capital and a structure of capital that takes account of intertemporal patterns of production with resources allocated among the different stages of production in accordance with the interest rate.

At 10:05 PM, October 02, 2008,  William H. Stoddard said...

From the reading of Austrian economics I've done, it appears that the serious Austrians don't believe that inflation (in their sense of an increase in the money supply) leads to low interest rates, either. That's more a form of vulgar Austrianism (in the same sense as "vulgar Marxism" or "vulgar libertarianism").

What the serious Austrian theorists seem to be saying is that government intervention to make credit available on easier terms will result in more people borrowing money; and since money is in fact banknotes, this will lead to a growth in the money supply, which will eventually lead to a general rise in prices. And since lenders are not stupid, they'll start demanding higher interest rates to compensate for the decline in purchasing power; in fact, I believe von Mises says explicitly that market interest rates combine components due to time preference, anticipated inflation, and riskiness of the loan. So the total effect is that when the central bank sets out to lower the interest rates, and thus encourage more investment, it also generates inflation that pulls interest rates back up and makes that investment unsustainable in the long run. At least, if I've got the theory right.

As to "the price of money," that terminological confusion is not all that uncommon in English. Consider that many people describe a prostitute as "selling herself," when in fact what prostitutes normally do is rent themselves. I think talking about "the price of money" does not reflect so much a false theory as a failure to make careful distinctions.

At 12:16 AM, October 03, 2008,  David Friedman said...

"Why would anyone get a long term loan at a high rate rather than roll a short term loan at a lower rate ? "

I said nothing about long term vs short term. If there is an ongoing inflation, it will raise both short term and (assuming it's expected to continue) long term nominal rates.

At 5:13 AM, October 03, 2008,  Anonymous said...

Yes I disagree. The effect on the interest rate will depend on how he spends his gold. If he uses it to make loans, he is in effect taxing all holders of gold and using the money to lend out, which lowers interest rates. If he spends the money on cavair, on the other hand, the effect is to raise the price of caviar.

Could you suggest a good textbook to help us understand the above? (Your brief chapter on inflation in "price theory" does not seem to enable to understand this.) Thank you.

At 5:57 AM, October 03, 2008,  Arthur B. said...

I said nothing about long term vs short term. If there is an ongoing inflation, it will raise both short term and (assuming it's expected to continue) long term nominal rates.

The short term rate is controlled by the fed via the FOMC, why would it rise with inflation ?

At 7:34 AM, October 03, 2008,  Gene Callahan said...

"It is a loss of wealth, as firms discover that their assets, in particular mortgages and securities backed by mortgages, are worth less than they thought."

But that's not a loss of wealth! If I fantasize that there is a million dollars in my closet, but, when I look, am forced to admit that there is not, I have not lost a cent of wealth!

At 7:43 AM, October 03, 2008,  Gene Callahan said...

Well, later in your post you seem to recognize the very thing I said above -- so maybe I was jumping on what was only a slip of the pen.

At 8:07 AM, October 03, 2008,  Arthur B. said...

William, you may be referring to the article "Ten Great economic myths" by Rothbard which says roughly the same thing.

I think it makes sense if the central bank is pursuing a money supply targeting policy as was the case with Volkner. After an inflationary period, restricting the money supply will indeed lower interest rates.

However with interest rate targeting it seems that interest rate would only depend on the expectation of the fed's decision and risk premium.

At 1:14 PM, October 03, 2008,  David Friedman said...

Arthur seems to think the central bank can simply set a short term interest rate. But suppose the rate they set is much lower than the equilibrium rate--as it would be if they ignored the inflation premium on nominal rates. There will then be an almost unlimited demand by banks to borrow from the central bank money that they can lend out at a higher rate.

Where does the central bank get the money to lend? If it prints it, you get a faster and faster inflation making the problem worse and worse. It isn't as if the central bank has an unlimited supply of capital available to lend out in order to hold down interest rates.

A central bank can affect short term rates a little, because it has some capital available to lend. But it can't hold them very far from the equilibrium level. As you can easily check--I'm sure the figures are webbed--when the U.S. had double digit inflation rates it also had double digit interest rates.

At 5:19 PM, October 03, 2008,  William H. Stoddard said...

Arthur seems to think the central bank can simply set a short term interest rate. But suppose the rate they set is much lower than the equilibrium rate--as it would be if they ignored the inflation premium on nominal rates. There will then be an almost unlimited demand by banks to borrow from the central bank money that they can lend out at a higher rate.

Thank you, David. That's the point I was thinking about trying to make, but I hadn't worked it out as clearly as you have here. I think that's a sound analysis, and neatly explains why credit expansion is unsustainable in the long run.

At 8:17 AM, October 04, 2008,  Arthur B. said...

Thanks, I was coming to something close to it but it wasn't really clear, now it is. The central bank does not so much raise interest rate to fight previous inflation, it let them rise to avoid inflation getting worse.

At 12:29 PM, October 04, 2008,  David Tomlin said...

That series of events cannot happen now because the FDIC insures bank deposits.

I've been hearing this since I was a kid, and I've been skeptical of it for almost as long. Government 'insurance' just adds another layer to the Ponzi pyramid, which, like Tinkerbell, can survive only as long as people believe in it.

At 11:02 AM, October 05, 2008,  William H. Stoddard said...

Actually, I look at government insurance of bank deposits a bit differently.

Here in California, we suffer from bad fires starting in wilderness areas. Now, at least at one time, it was the accepted policy to put out such fires, for fear that any fire, even a small one, could go out of control and cause major property damage. But without regular small fires, underbrush and detritus accumulated from year to year, and when there finally WAS a fire that wasn't stopped, it had huge amounts of fuel and became a catastrophe. At least in theory, it's starting to be recognized that a lot of smaller fires do less harm than one huge one.

Now, deposit insurance works to limit the tendency to bank runs, which seems like a good thing, because bank runs hurt people and cause banks to fail. But that damage is localized. Once the Federal Reserve was set up, banks were at far less risk of failure. This means that if a bank made unsound investments, it would not face a bank run, or fail, or be taken over by a different bank. So the bad investments could accumulate, until the whole system had a critical mass, great enough to cause a huge financial crisis. And the knowledge of being protected against bank runs creates a "moral hazard" situation, the classical weakness of insurance schemes and the one that well-designed insurance contracts are written to prevent: a bank that doesn't have to worry about runs can go after the higher returns of risky investments with much less fear, leading to a higher fraction of unsound investments.

The forest fire analogy does suggest that there might be a case for some sort of emergency government action; when you're in a huge fire, the first priorities are escaping with your life and putting the fire out. On the other hand, we don't deal with huge disasters by making the National Guard totally immune to oversight, either. Paulson's request for immunity to legislative and judicial review amounted to calling for establishing a dictatorship. Historically, I believe the correct term for that is Caesarism, and had it been granted the republic would certainly have been doomed—as opposed to just probably, as seems to be the case now.

At 12:58 PM, October 05, 2008,  Anonymous said...

But that's not a loss of wealth! If I fantasize that there is a million dollars in my closet, but, when I look, am forced to admit that there is not, I have not lost a cent of wealth!
Poor analogy. If you buy a Picasso painting, and later find out, that it's a forgery, then you have loss of wealth. The loss happened when you made the purchase, but being unaware of that, at the time, the loss will materialize itself now.

At 4:58 PM, October 05, 2008,  Gene Callahan said...

"Poor analogy. If you buy a Picasso painting, and later find out, that it's a forgery, then you have loss of wealth. The loss happened when you made the purchase, but being unaware of that, at the time, the loss will materialize itself now."

Yes, in that case I lost wealth -- but there still is no general "loss of wealth" in the economy -- just someone else has it now.

This is important, because when the Dow tanks, you hear reporters saying "The economy lost \$1.2 trillion in wealth today." Well, no it didn't. You could see Fritz Machlup's excellent "How to Think About Losses" in this regard:
http://mises.org/story/916

At 1:24 PM, October 06, 2008,  Anonymous said...

What we are observing is not a drop in the money supply

At 1:57 AM, October 08, 2008,  Sukrit said...

To the last anonymous: here's an article by Robert Higgs discussing the myth of a credit crunch. Here's another one.

That's an interesting point David raises about the conditions not being identical to the Great Depression (in that there is no sharp drop in the money supply). Presumably then, Milton were he alive today, would not advocate a policy of more inflation through a rate cut, as one Cato scholar - Gerald O'Driscoll - has.

Not that my opinion matters, but I think the Austrians are right on the issue of monetary policy. They want to stimulate the economy in times of depression through lower taxes and less regulation, not through a deliberate policy of inflation - which does lead to some malinvestment, even if there's doubt as to how much.

At 1:53 PM, October 08, 2008,  David Tomlin said...

When the money supply is increasing and prices are rising, nominal interest rates are high . . .

This implies that it's all instantaneous. Everyone raises their prices as soon as the money supply starts to rise, and lenders immediately start demanding higher nominal interest rates in anticipation of price inflation continuing into the future. Maybe this would happen if everyone had perfect information, but not in the real world.

'For most major Western countries, a change in the rate of monetary growth produces a change in the rate of growth of nominal income about six to nine months later. . . . The changed rate of growth of nominal income typically shows up first in output and hardly at all in prices. . . . The effect on prices . . . comes some twelve to eighteen months later, so that the total delay between a change in monetary growth and a change in the rate of inflation averages something like two years.' (Milton Friedman, Money Mischief, pp. 47-48)

Higher nominal interest rates are not a direct effect of current inflation. They are caused by expectations of future inflation, which are affected by things like how long price inflation has continued, people's past experience (or lack thereof) with prolonged inflation, and expectations about government policies.

'In the major Western countries, the link to gold and the resulting long-term predictability of the price level meant that, until sometime after World War II, interest rates behaved as if prices were expected to be stable and neither inflation nor deflation was anticipated. Nominal returns on nominal assets were relatively stable, while real returns were highly unstable, absorbing almost fully inflation and deflation. . . . Beginning in the 1960s, and especially after the end of Bretton Woods in 1971, interest rates started to parallel rates of inflation. Nominal returns on nominal assets became more variable; real returns on nominal assets, less variable.' (Ibid, p. 50)

At 9:15 PM, November 07, 2008,  Steve said...

I had the same reaction as Chris Callahan: (much of) the "loss of wealth" in the past two months has really been a loss of estimated wealth from estimates that had grown steadily more optimistic over several years.

Which still means people are unwilling or unable to lend one another money, because they no longer fantasize that they have a million dollars in the closet, and because furthermore they no longer trust their would-be borrowers' assertions that they have a million dollars in the closet. The real loss is not of wealth but of trust, which effectively imposes a transaction cost on almost the entire economy.

At 8:46 AM, January 22, 2009,  海賊王 said...

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At 11:17 PM, March 16, 2009,  moto said...

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At 9:37 AM, July 30, 2010,  Ewpew said...

Hello.
I am a high school student with no further education whatsoever in economics. I dare not call myself anything such as an academic of economics, as a simple act of humility and for the sake of saving myself from any self-embarrassment.

I believe your depiction of the price of money is somewhat inaccurate.

Anyway, I believe that interest rate has sometimes been termed as the price of money because it is somewhat synonymous with the y-value of a money market, determined by the interaction between money demand and money supply. Interest rate is actually the price paid for the use of (borrowed) money. The price of money is the price at which money is being traded in the money market, in the strictest sense of economics. It is never the value of money, what money can buy and whatsoever, that is completely irrelevant in the money market.