All Commentary
Thursday, October 15, 2009

How Much Money Does an Economy Need?

In How Much Money Does an Economy Need? Hunter Lewis addresses some of the most fundamental questions of monetary policy in a question-and-answer format. For a subject often clouded by technicalities, the language is refreshingly plain. Sometimes too plain, perhaps, to satisfy an academic economist. But academic economists aren’t the intended audience. The book can be read profitably by interested laymen, including bright high-school students.

Lewis poses excellent questions and gives fairly good answers. His questions include: Should prices in general be stable, fall, or rise? and Should the stock of money grow continuously, never, or sometimes? He conducts a dialog with himself over these questions, first defending a “yes” answer, then a “no,” and then offering additional replies and counter-replies. His sympathies lie with what he describes as “the Austrian, laissez-faire, or free-market point of view,” but he endeavors to represent the alternative Keynesian view fairly.

Lewis is to be applauded for presenting the case for letting prices fall in a growing economy. Unfortunately he appears to have overlooked some of the strongest previous presentations of that case. We must distinguish between a harmless deflation, where technological progress or other sources of improved productivity lower costs and thereby gently draw prices down, and a harmful deflation, where shrinkage in the stock of money or its velocity brings unsold inventories and thereby painfully forces prices down. Lewis recognizes a distinction between gentle and painful, but oddly claims that, in the view of its defenders, “deflation is always good,” even when “quite painful.” Claiming that deflation is always good is absurd because there is no benefit from deliberately creating a deflation by shrinking the money stock. Auric Goldfinger’s plan, in the James Bond story, to nuke the gold in Fort Knox, thereby raising the purchasing power of his own gold, was the plan of a villain not a hero. Just as a central-bank-engineered monetary expansion disrupts the economy and causes misallocation of resources—something Lewis recognizes—so too does a central-bank-engineered monetary contraction.

To his credit Lewis identifies the error of monetary expansionism: “If you have four apples and a dollar, the dollar may help you price and trade the apples. But adding another dollar will not increase wealth; it will simply raise the price of the apples.” Unfortunately, he fails to identify the corollary error of deliberate contractionism.

In the second half of the book, Lewis discusses what he calls “the problem of banks,” meaning the question of fractional-reserve banking. Here Lewis—following and citing Murray Rothbard’s The Case Against the Fed—offers the view that fractional-reserve banking is prone to runs, “inherently destabilizing” for the broader economy, and should be outlawed as fraudulent. Uncharacteristically, he neglects to consider the other side: the historical studies indicating that free banking with fractional reserves is not run-prone but robust, the theoretical arguments for the efficiency and economically stabilizing character of free banking, and the jurisprudential arguments for the legitimacy of voluntary fractional-reserve arrangements based on freedom of contract.

Defenders of fractional-reserve free banking (the present reviewer included) would reject the claim that, like a central bank, “a fractional reserve bank can also ‘print’ new money” arbitrarily. Any bank in a competitive system issuing gold-redeemable notes and deposits is tightly constrained, unlike a monopoly central bank. Contra Lewis, the money supply in a fractional-reserve free banking system is neither “over elastic” nor “generally expanding.” Lewis might have consulted Mises’s The Theory of Money and Credit and Human Action more closely on these points.

Lewis does a good job of sketching the Austrian theory of the boom-bust cycle resulting from a central bank’s cheap-credit policy. And he sagely notes that when a central banker promises to inflate the economy and bail out financially troubled firms, “then it becomes more rational to speculate, to take excessive risk, and not at all rational to save, to take precautions, to be prudent. In this respect . . . so-called stabilization is actually de-stabilizing.”

The book contains three appendices, respectively concerning the Federal Reserve System and its operations, the gold standard and other international monetary arrangements and institutions, and nonmonetary cycle theories. The appendix on the Fed unfortunately gives an incorrect account of how the money multiplier and open-market operations determine the money stock.

The academic economist-reviewer cannot resist noticing some other errors. For example, no sensible view holds that a period of inflation typically or automatically leads to a period of deflation in a fiat money economy. A determined central bank can issue enough money to keep the price level rising continuously, as almost all have since the fiat era began in earnest in 1971.

Despite its shortcomings, this book is an interesting and useful introduction to the important question posed in its title.