Understanding Money Mechanics
by Robert P. Murphy
Mises Institute, 2021, 210 pp.
Robert Murphy aims to provide the “intelligent layperson a concise yet comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States” (p. 9), and he succeeds in doing so, but I do not propose here to concentrate on this overview. In the course of his “neutral presentation” of it, he makes a number of valuable points about Austrian theory and the American economy, and his immense talent for the clarifying analogy is everywhere to the fore. In what follows, I shall endeavor to explain a few of these points.
Calls to “End the Fed” have been going on for a long time, and many of us have with great enthusiasm supported Ron Paul in challenging federal control of our monetary system; but, Murphy says, in recent years the threat from the Fed has become worse than before. No longer does the Fed confine itself to trying to determine the economy’s monetary framework, but it now chooses particular companies in which to invest. By picking winners and losers in this way, it has arrogated to itself unauthorized power. As Murphy says,
In order to avoid the obvious invitation to corruption, the legislation authorizing the Federal Reserve put limits on what the US central bank could buy. After all, if the people running the New York Federal Reserve Bank [who are in charge of asset purchases] could create money electronically with which to buy specific shares of Wall Street stock, there would be vast opportunities for abuse…. In practice, the Fed lent money to newly created Limited Liability Corporations (LLCs) named “Maiden Lane”—referring to the street in New York’s financial district—that would then use the money borrowed from the Fed to purchase the desired assets. (p. 90)
In his discussion of the Austrian theory of the business cycle (ABCT), Murphy calls attention to something rarely emphasized by other writers. As the theory is often represented, the cycle starts when the central bank expands bank credit, leading to a drop in the loan rate of interest, which creates an artificial boom. The central bank can do this only when at least a very substantial part of the money supply consists of fiat money, i.e., money not backed by a commodity such as gold. For that reason, critics of the ABCT say, the theory cannot explain the business cycles that occurred before the onset of modern central banking.
Not so, says Murphy, and for two reasons. First, “the Austrian theory of the business cycle isn’t based on fiat money. Indeed, Ludwig von Mises developed his explanation of the boom-bust cycle at a time when he didn’t even think fiat money had ever been in use. So clearly, the Misesian theory of recessions isn’t directly tied to the abandonment of the gold standard, and it’s therefore not a problem for Austrians to explain depressions (or ‘panics’) that occurred during the days of the classical gold standard” (p. 105).
Second, the ABCT isn’t dependent on the existence of a central bank, but rather on fractional reserve banking.
But there is no doubt that Mises’s theory of the business cycle is based on the ability of the private commercial banks to create money through the issuance of new loans using deposits that the depositors still think are in their checking accounts. It is true that central banks can influence these commercial bank practices in a harmful way, but the Misesian theory isn’t about central banks (or fiat money) per se…. when modern fans of Mises discuss the business cycle, they should be careful to avoid claiming that that it necessarily starts with a central bank injecting new fiat money into the economy. (p. 107)
Murphy goes on to explain why booms cannot be permanently sustained: the physical resources are not present to carry to completion all the investments brought about by lowering the rate of interest on loans through the expansion of bank credit.
Imagine a builder working on a house. Thinking he has a certain quantity of materials—bricks, wood, glass, shingles, etc.—at his disposal, he draws up blueprints and assigns various skilled and unskilled workers to their tasks. But suppose that the builder had overestimated how many bricks he originally had. In that case, the house depicted in his blueprints would be physically unsustainable. The moment the builder realized his error—in other words, when he realized that his actual supply of remaining bricks was smaller than what his plans required—his immediate response would be to tell everyone on the work site to halt! (pp. 110–11)
Keynesians have a well-known objection to the master-builder argument. They say that it assumes that resources are fully employed. If they aren’t, the boom can be sustained because credit expansion will bring unused resources into production. As you might expect, Murphy isn’t convinced. Keynesians have no explanation for the existence of idle capacity. By contrast, “according to Mises’s theory of the business cycle, the existence of ‘idle capacity’ in the economy doesn’t just fall out of the sky, but is instead the result of malinvestments made during the preceding boom” (p. 194). He further notes that their view fails to account for the historical facts. “Empirically, we note that during the 1930s, governments and central banks around the world engaged in the most Keynesian policies in history to that time … the Federal Reserve in the early 1930s expanded the monetary base and slashed the interest rates to then record lows” (pp. 163–64). These policies failed to restore prosperity. Doesn’t this falsify the Keynesian account? Keynes did not claim that his theory was an a priori truth, so it wouldn’t be a good answer for Keynesians to retreat in the face of failure of the logical validity of their theory.
They do have another answer, though. They say that the government did not spend enough and this was the reason the Great Depression continued throughout the 1930s. Murphy asks them a devastating question:
If the fundamental Keynesian explanation for the Great Depression is that governments were too timid when it came to deficit spending, then why didn’t the Great Depression happen earlier, when everybody admits that government did even less during financial panics? No, a much more sensible explanation of the historical record is staring us in the face: the depressions (or “panics”) of the nineteenth and earlier twentieth centuries played out according to the theory developed by Ludwig von Mises. Yet during these crises, governments largely remained aloof, and that’s why the economy recovered. (p. 164)
Keynesians are not the only economists who oppose the ABCT, and Murphy addresses a number of the competing accounts. In his comments on Scott Sumner’s argument that the monetary policy of the Fed should be assessed by whether the growth rate of nominal gross domestic product has risen by what he deems the appropriate amount, Murphy displays the gift for the apt analogy which I mentioned at the start of this review. He says that since “the Fed allowed NGDP growth to (eventually) collapse, Sumner argues that by definition this is a ‘tight’ central bank policy” (p. 174). Murphy objects that this definition makes it impossible to show that Sumner’s policy advice is wrong.
Consider a medical analogy: suppose a patient is suffering from fever, running a temperature of 103 degrees. One group of doctors recommends injecting the patient with substance M, in order to cure the fever…. Indeed, imagine if the doctors who think that substance M is a helpful medicine wanted to define the M treatment in terms of the fever. That is, if after they had injected the patient with unprecedented amounts of M, whether the fever had stayed the same or gone up, the doctors declared, “We just made the patient sicker with our shift to restrict the M treatment.” This would be Orwellian and obviously would make it virtually impossible to figure out whether more or less M was what the patient needed. (pp. 174–75)
Murphy has no use for modern monetary theory (MMT) either, and I’ll conclude with his comment on the notion held by most members of the school that money didn’t originate as a commodity but rather by the government’s declaration that taxes had to be paid in a new monetary unit. “The only problem [with this theory] is that it’s demonstrably false…. The MMT explanation of where money comes from doesn’t apply to the dollar, the euro, the yen, the pound…. Come to think of it, I don’t believe the MMT explanation applies even to a single currency issued by a monetary sovereign” (p. 200).
Understanding Money Mechanics is an outstanding book, and readers of it will gain much from the insights of its talented and erudite author.