[swalsh81]

LearnLiberty is putting on a course on the great depression taught by Steve Horwitz. So far, its been pretty good in discussing the Austrian Business Cycle as it relates to the 20s. This week, he get into the time just after the crash and seems to be taking quite a monetarist view and I have a few questions.

He says that the supply of money fell. One of the results, was that the demand to hold money greatly increased, leading to pulling cash from banks and the runs on the banks. He says the proper response by the Fed would have been to increase the supply of money in the economy to meet the demand to hold money. I did ask him before whether this was an argument in favor of a central bank and he said that it was not. But, in a non-ideal system where we do have a central bank, this is what they should have done.

So, if I understand the video properly, my questions are

1. Where did this money go? did it just go to cash or was there an actual net drain of money from the economy as a whole?

2. Doesnt the fact that banks were unable to meet their liabilities in a bank run leading to massive bank failures expose an inherent problem in the banking system in that they do not have the liquidity they claim to have based on the amount of demand deposits?

3. Wouldnt the promise or expectation of the Fed pumping more money into the economy in response to a higher demand for money lead to a moral hazard allowing banks to loan out more than they should and may even artificially increase the demand to hold money?

4. Is there really a demand to hold money per se or is it a demand to hold purchasing power? And, if the latter, doesnt the price inflation caused by monetary inflation just push off the problem until later when the price inflation has come to full realization and the money being held loses its purchasing power?

There is probably something else and other comments on the video or the monetarist perspective would be of help.

[jmherbener]

1. The money stock is money plus money substitutes. The money stock declined from 1930-1933, but the amount of cash or currency did not. The decline in the money stock came from a decline in bank deposits. People generally were trying to increase their liquidity, banks included as they built up excess reserves.

2. Yes, by cutting reserve requirements in half after WWI and “managing” the money stock to be counter-cyclical, the Fed created the conditions for the massive bank failures. By 1929, Banks were highly illiquid.

3. Yes, and the moral hazard problem was made worse by Glass-Steagall in 1932 and FDIC deposit insurance in 1933.

4. There is a demand to hold money, i.e., the general medium of exchange, and not just purchasing power, which could be held in any asset. The amount of money a person will hold to satisfy his preference will depend on its purchasing power. So, you are correct that if the government inflates the money stock and lowers its purchasing power that will stimulate the demand for money and make price inflation worse. This is the process that can lead to hyperinflation.

On the Great Depression, take a look at Benjamin Anderson, Economics and the Public Welfare:

http://library.mises.org/books/Benjamin%20Anderson/Economics%20and%20the%20Public%20Welfare.pdf

[swalsh81]

can I ask what your view is of the monetarist argument that is made? or is that more or less covered int he Anderson book?

debt deflation has been something else that has come up in discussion. Do you have a comment on debt deflation?

[jmherbener]

Anderson provides the Austrian counter to the monetarist. Also, Bob Murphy addresses the monetarist argument directly in his Politically Incorrect Guide to the Great Depression.

Irving Fisher’s theory of debt deflation begins with the assumption that the economy somehow becomes over indebted. If one starts the analysis at the beginning and not in the middle of the sequence of events, then one sees that over indebtedness comes through a prior monetary inflation via credit expansion. The malinvestments that must be liquidated to set the economy back on the right track occur during the boom. The boom is unsustainable because the built up production structure fails to satisfy people’s time preferences. The financial correction with its debt defaults and bank deposit shrinkage is not the cause of the ensuing losses and reallocation of resources. The financial correction merely reveals the malinvestments and misallocations that were made during the boom.

On the economics of deflation, take a look at Guido Huelsmann’s book, Deflation and Liberty:

http://library.mises.org/books/J246rg%20Guido%20H252lsmann/Deflation%20and%20Liberty.pdf

[swalsh81]

thanks for all the links. That was what struck me about debt deflation. It seemed to me that it must be caused by something and is merely a symptom of the underlying credit expansion and I did not see how it would be legitimate for a central bank to “meet demand” for holding money if it is the same central bank that caused problems in the first place

I think I have a good handle on (at least the basics) of Austrian business cycle theory, I would really like to get into some more specifics and down in the depths of macro theory.

[jmherbener]

Take a look at Huerta de Soto’s book, Money, Banking Credit, and Economic Cycles. Chapters 5 and 6 covers the Austrian theory of the business cycle and chapter 7 critiques Keynesian and Monetarist explanations.

http://mises.org/books/desoto.pdf

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