[jmherbener]

Demand and supply schedules are constructed by making conjectures about the different amounts of a good buyers would prefer to buy at different prices, other things equal, and the different amounts of a good sellers would prefer to sell at different prices, other things equal.

The construction of a demand schedule begins with an actual purchase that a buyer makes. For example, yesterday I bought one package of 500 sheets of printer paper at Wal-Mart at a price of $12. We can conjecture that at a price high enough, I would have foregone purchasing paper and at a price low enough, I would have purchased more than one, or at least not less than one, package of paper. This construction reveals the law of demand. The price elasticity of demand refers to how sensitive the buyer’s purchase is to a change in price. Elastic demand means that the buyer changes the amount he purchases a lot in the face of a given change in price. Inelastic demand means that the buyer changes the amount he purchases a little in the face of the same change in price.

Take a look at David Gordon’s treatment of demand and supply in his book, An Introduction to Economic Reasoning:

http://library.mises.org/books/David%20Gordon/An%20Introduction%20to%20Economic%20Reasoning.pdf

For a more conventional treatment, see Bob Murphy’s in his book, Lessons for the Young Economist:

http://library.mises.org/media/In%20Studio%20Interviews/Lessons%20for%20the%20Young%20Economist%20Robert%20P%20Murphy.pdf

[jmherbener]

The Fed regulates commercial banks. One of its regulations concerns reserves banks hold against their deposits. The Fed requires a bank to hold roughly 10 percent of the total that all of the bank’s customers have in their checking accounts at the bank. The Fed also dictates that banks can hold as reserves either Federal Reserve Notes (or currency) or checking account balances at the Fed.

Markets clear at the price at which the quantity of the good that buyers want to buy is the same as the quantity of the good that sellers want to sell. At higher prices there would be excess supply and at lower prices there would be excess demand. So each type of loan has an interest rate that clears the market, at which the quantity of credit borrowers want to borrow is the same as the quantity of credit lenders want to lend.

[jmherbener]

Both fiscal and monetary policy cause malinvestments in the capital structure. The difference is distortions from fiscal policy can be permanent but distortions from monetary policy are self-reversing.

Reduced government spending, as in winding down after war, does not cause a bust. Instead it frees entrepreneurs to reallocate investment into profitable lines and therefore, leads to an improvement in consumer satisfaction.

Take a look at Robert Higgs’s great article on the economy after the Second World War:

http://www.independent.org/newsroom/article.asp?id=138

[jmherbener]

When the Fed buys things it either prints currency or writes checks on itself. Commercial banks can use either currency or checking account balances at the Fed as reserves against the deposits their customers have. Banks trade reserves over night. The interest rate on these loans is called the Federal Funds Rate. The Fed targets this rate when conducting monetary policy.

Here is information on the Federal Funds Rate:

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

On the free market, the fundamental interest rate is determined by people’s time preference, i.e., their preference for sooner satisfaction instead of the same satisfaction later. Because of this preference, present money commands a premium over future money. People with less intense T.P. will lend to people with more intense T.P. and the fundamental rate of interest will be at the level that clears the market. In addition to the fundamental rate, the interest rate on each type of loan will have components to account for maturity, uncertainty, and changes in the purchasing power of money. For example: the 3-month, treasury bill rate will be lower than the 30-year, BBB rated corporate bond rate.

Here is some data on market interest rates:

http://research.stlouisfed.org/fred2/categories/22

[jmherbener]

The state’s policies, both fiscal and monetary, generate unjust wealth transfers through trade. But not everyone is tainted by these policy sins. When my wife and I bought lunch at Hot Head Burritos today both we and HHB benefited. The value of the lunch to us relative to money exceeded the value of the lunch relative to money to others who did not buy it. The nature of our trade was not altered because we used fiat money.

I agree that fiat money and fractional reserve banking empower the state more than the power to tax. Ending the Fed and turning production of money over to private enterprise would restore more of our liberty than any other single reform. Even so, the power to issue fiat money is not the source of the other distortions. If we had a private monetary system, the state would still distort the economy by taxing and regulating our activity and running its own production facilities.

Economics helps us to discern the effects of each of the state’s activities.

[jmherbener]

It is true that the pattern of prices, production, and income on an unhampered market would be entirely different than the pattern of prices, production, and income on a market economy hampered by a central banking that issues fiat money.

But it doesn’t follow from that conjectural claim that the pattern of prices, production, and income on a market economy hampered by a central bank issuing fiat money bears no relationship to people’s preferences.

By exercising its legal monopoly of printing fiat money, the state unjustly transfers resources from producers in the economy to itself. State officials and those who produce goods for the state, then, earn income unrelated to the satisfaction of people’s preferences in society. But this effect cannot extend to every producer in the economy unless the state adopts central planning. So in a hampered market economy their are lines of production support by the coercive power of the state and other lines of production not so supported. In the latter lines, the producers do earn incomes from the value of their productive services in satisfying the preferences of others and entrepreneurs do earn profit from their superior foresight in satisfying the preference of others. Consumer electronics would be an example of such a line of production.

The coercive taint on fiat money is not a character trait of the money as a medium of exchange it is in the use of the money by the state to unjustly transfer resources from producers to itself. And this effect is limited unless the state takes over all production.

[jmherbener]

Bonds issued in the past have stipulated interest payments that do not change over the life of the bond. For example, suppose a twenty year bond issued in 2000 had a face value of $10,000 and paid $600 a year in interest to the holder. Then the interest return on that bond when it was issued was 6 percent. Now suppose that a twenty year bond issued today with a face value of $10,000 paid $200 in interest to the holder for an interest rate of 2 percent. Investors today would want to buy the 2000 bond and not the 2013 bond. They would bid for the 2000 bond until its price rose to approximately $30,000 so that the interest return on that bond was also 2 percent. If interest rates in 2016 have risen back to 6 percent, then the price of the 2000 bond will have fallen back to $10,000 (making its interest return conform to the market rate of 6 percent) and the price of the 2013 bond will have fallen to approximately $3,333 (making its interest return conform to the market rate of 6 percent).

The general principle is that the interest return on all bonds issued in the past must conform to the current interest return, which will also be the interest return on newly issued bonds. The interest return itself is determined by people’s willingness to save and invest.

[jmherbener]

The value a person places on a good is not “based” on money, but expressed against the value he places on money. If I value an iPad more than I value $500, then I gain if someone sells me an iPad for $500. The seller must also gain by the trade, i.e., he must value $500 more than he values the iPad, otherwise he would not trade. If there is another person who values the iPad more than $400 but less than $500, then we can conclude that if the seller sells to the first buyer instead of the second buyer, the iPad has been allocated to the person who values it the most compared to money.

If people do not use money in trade but whatever barter goods they happen to have, then it cannot be determined which of the buyers values the good he has to sell more than another. One offers two beaver pelts for the iPad and another offers a chord of wood. The seller can tell which offer by the buyers he himself values more. But which buyer values the iPad more highly is indeterminate.

Labor, also, cannot be used to determine who values something more highly. The units of labor are different from person to person. If one person values the iPad for 6 hours of his labor and another person values the iPad for 12 hours of his labor, nothing can be inferred about which person values it more. The different units of money, however, are homogenous. So it is possible to say whether one person values something more highly relative to money compared to someone else.

[jmherbener]

Carl Menger, the founder of the Austrian School of economics developed the economic theory of the origin of money. He argued that for something to emerge as a medium of exchange, it must have existing exchange value. Otherwise, people would not know how much of it to give in exchange for things they buy or take in exchange for things they sell. In order for something to have existing exchange value, it must currently be traded on the market or be introduced as a claim to something currently traded on the market. So gold originated thousands of years ago as a medium of exchange because it was already being traded as a good in markets, was highly marketable, and had desirable properties as a medium of exchange, e.g., durability, divisibility, portability, and so on. Once gold coins existed as money, claims to gold coins can come into existence. Bank notes or checkable deposits are money substitutes as long as people trust that the issuer will make good on his claim to redeem them for gold coins. Fiat money comes into existence first as a money substitute claim for existing money and then the issuer of the claim, namely, the state, breaks its claim. From that point on fiat money can continue as money without any reference to its past backing. It continues as money solely because people anticipate that other people will continue to accept it as money in trade. Federal Reserve Notes came into existence in 1914 in exactly this manner. The Fed redeemed FRNs at par with gold coins and claims to gold coins. The government completely broke its promise to redeem FRNs for gold money in 1971. From that point on the FRNs have been fiat money. The Euro also came into existence in the same way. It started as a redemption claim for each of the national currencies of the EMU countries. Over a few years, each of the countries broke its promise to redeem Euros for its national currency. From that point on the Euro has been a fiat money.

Here is Menger on the origin of money:

http://library.mises.org/books/Carl%20Menger/On%20the%20Origins%20of%20Money.pdf

[jmherbener]

Saving-investing is done to satisfy time preferences. A person gives up present satisfaction for a more valuable future satisfaction. Because people have different intensities of time preferences, those with lower time preferences can save and invest by lending to those with higher time preferences. The rate of interest emerges that clears the time market. Savers, however, have an array of investment opportunities. The main categories are consumer loans, producer loans, and direct investment in production. Bonds would be one type of producer loan while stock would be one type of direct investment in production. The holder of a bond has a claim on predetermined payments of future money from the enterprise. The holder of a share of stock has a proportionate claim on the equity of the enterprise. Investment in bonds earn interest while investment in stock earns interest plus profit (or minus loss).

However, because of uncertainty no matter the investment a person chooses, it is speculative. Thus, people can trade in and out of claims, e.g., bonds or stocks, based on their speculations about the future market values. In secondary markets, bonds and stock are trading from one group of saver-investors to another. The buyers have lower time preferences or higher expectations about future market values or both than sellers. They consider the anticipated return sufficient to compensate for their time preferences. The sellers have higher time preferences or lower expectations about future market values or both than buyers. They consider the anticipated return insufficient to compensate for their time preferences.

Secondary markets facilitate the rearrangement of ownership of claims from those who value them less to those who value them more.

[jmherbener]

Your example illustrates the first step of the business cycle, not efficiency. The issue of fiduciary media by banks leads to malinvestments during the boom which must be liquidated during the bust. Likewise, during the housing the boom the additional houses produced (and the additional capital capacity produced to support housing production) was not efficient.

It is only better for society to have another restaurant built if it proves to produce goods more valuable to people in society than the alternative production facility that could have been built with the same resources. That the restaurant owner pays back his loan is not a sufficient condition to prove social benefit. Lots of homeowners were paying back their mortgages during the housing boom.

In the market, profit and loss calculations reveal when the use of resources in one line of production have greater value than in another alternative line of production. An enterprise earns profit if the revenue generated by the sale of its output exceeds the costs incurred from the purchase of its inputs. The revenue generated is determined by the demand people have for its output. The costs incurred is determined by the demand other entrepreneurs have to produce their output which, in turn, is determined by the demand people have for their output. An enterprise earns profit by compensating the input owners for the loss of value they cannot receive from other entrepreneurs and then uses the inputs to produce output that people value more highly than that which would have been produced by other entrepreneurs.

Now apply these general principles to banking. If a bank intermediates credit, then they compensate savers by paying interest to borrow funds from them. Because they have lent money to the banks, the savers must reduce their demands for goods. But they have willingly entered into an agreement to do this. If the bank issues fiduciary media, then it pays no opportunity cost to obtain command over these funds. And yet, when it lends the funds out to borrowers, they are able to bid resources away from other people without anybody agreeing to such restrictions in their command over resources. Such activity is inefficient on these grounds alone.

We can come to the same conclusion about fiat money. If the government prints more fiat money and spends it to build three more bridges is society better off? Clearly not. All such spending of the government is inefficient by the nature of how the resources are transfers out of the hands of some people and into the hands of other people. Unless this is done in voluntary exchange under the guidance of economic calculation, then the activity is socially inefficient.

[jmherbener]

These arguments about the technical efficiency of media of exchange miss the point of economic efficiency. To use an analogy, consider the thermal efficiencies of different types of engines. Electric engines may have higher thermal efficiency than gasoline engines, but that does not determine which engine is economical efficient, i.e., superior in economizing resources. To determine economizing or economic efficiency, the only guide is economic calculation, i.e., the profitability of production.

In like manner, to determine the economically efficient media of exchange, one must refer to the profit of its production. The issue of fiat money and fiduciary media are not subject to the test of profit and loss. It is always profitable to issue more of them. Put another way, the issuer do not bear the opportunity cost suffered by others when of issuing more. Neither fiat money nor fiduciary media, therefore, can be part of the market economy. They are foreign elements because their production cannot be determined by profit and loss.

The arguments about the technical efficiency of money falsely conclude that the monetary arrangement that allows people to minimize the holding of money proper (or as you put it, maximize velocity) is the economizing monetary system. This is analogous to someone concluding that choosing electric engines over gasoline engines economizes resources in society because electric engines have higher thermal efficiency than gasoline engines.

[jmherbener]

Here are some Mises Daily articles on austerity:

https://mises.org/daily/6289/

http://mises.org/daily/5939/

http://mises.org/daily/5215/Is-Budget-Austerity-ModernDay-Hooverism

And a Free Market article:

http://mises.org/journals/fm/February2013.pdf

[jmherbener]

There is one faulty step in your argument. Banks do not lend out their reserves. They hold them against their fiduciary issue. When conditions return to normal and banks begin to lend again, they will do so by issuing fiduciary media and creating credit not by lending out their reserves. In that way, the banks will earn 0.25 percent on their reserves and the market interest rate on their created credit.

The reason the banks are not issuing much additional fiduciary media nor creating much additional credit is that they are still liquidating the bad loans accumulated during the boom from their balance sheets. Given the fragility of financial markets, banks prefer to hold a larger portion of their assets as cash on their balance sheets instead of loans and securities.

So given the unusual demand and supply conditions, credit markets are clearing at the current low interest rates. If banks raised their rates, they would have excess supply of credit.

[jmherbener]

The ERE is an imaginary construct used by economists to decompose net income into profit and interest. Interest is that part of net income that accrues to capitalist-entrepreneurs to compensate for their time preferences. They pay money to buy inputs before they receive money from the sale of outputs. Their saving-investing earn interest. Profit is that part of net income that accrues to the capitalist-entrepreneurs for their superior foresight. Those who more accurately anticipate the demands of consumers earn profit from their production decisions and those who less accurately anticipate consumer demands suffer losses.

To separate and analyze these two factors, economists pose the ERE. The ERE is constructed to eliminate uncertainty and therefore, profit. In the ERE, the patterns of demands are perfectly anticipated. Because of this, the profit that can be earned by reallocating resources toward more profitable and away from less profitable lines is exhausted. Although the ERE presents some philosophical puzzles, the absence of volition is not one of them. All that needs to be assumed is that the class of capitalist-entrepreneurs have perfectly accurate foresight about what other people will demand. This does not require that consumers be reduced to robots only that capitalist-entrepreneurs be elevated to demi-gods. Everyone still has his or her preferences and they choose and act accordingly. There would still be prices of outputs and inputs, production, earning and disbursing of incomes, and so on. In similar fashion, people would still have time preference and therefore, interest rates would exist in the ERE and interest income would be earned by capitalist-entrepreneurs.

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