Bob Murphy comments on my debate with Jim Manzi. He concludes

[Smith’s] self-described “defense of economics” (by which he means mainstream macroeconomics) doesn’t recognize that the empirical record is entirely consistent with those models being horrible.

Let me put it in other words: The Austrian critique of artificially low interest rates is that they fuel an unsustainable boom, sowing the seeds for an eventual crash. Yes, after a particular collapse, it’s possible for the central bank to do it all again. This might appear to give a “soft landing,” and indeed people might laud the Maestro for his deft manipulation of the federal-funds rate.

But tinkering with electronic bank reserves doesn’t expand the actual supply of capital goods. Eventually, the inflationary chickens will come home to roost. The ultimate bankruptcy of monetary pump priming — of flooding the credit markets with money printed out of thin air — occurs when short-term interest rates hit zero, and can go no further.

So I should start by saying that I don’t know enough about the modern Austrian critique to offer a full rebuttal of the entire school of thought. I hope Bob continues the dialog and that through it we can both learn more.

I can address the points that Bob brings up.

First, is that Fed policy has at times been less than ideal. You won’t get arguments from me on this one. Though, I think its for different reasons. Currently, of course I think that the problem is that monetary policy has been too tight.

However, saying that the money supply could have been managed better is different than saying that our understanding of how monetary policy works is wrong. For one thing our understanding has evolved considerably over the last half century. For another, the all central banks seem nervous about taking the steps proscribed by theory.

Second, Bob seems to be implying that that monetary policy can’t influence the stock of capital goods but he does recognize that monetary policy can induce a “boom.” The problem with this assertion is that capital investment rises during booms.

Here are GDP, Investment in Nonresidential Structures and Investment in Equipment and Software, all plotted on the same scale.

FRED Graph

As you can see Investment in capital is actually more volatile than the overall economy and moves with it. Here GDP is scaled on the right so that co-movement is more clear.

FRED Graph

If we believe that monetary policy can cause booms then we believe that monetary policy can cause changes in investment.

Now my sense of Austrian business cycle theory was that it acknowledged this but argued that we would cause malinvestment. That is, we would cause investment in things which should not have been invested in. Eventually people will realize this and the economy will crash.

My issue with this is that if the Fed is causing too much investment this implies that people should have been consuming more, either in the form of more consumption goods or more leisure. The problem with the consumption goods story is that consumption moves along with investment and overall GDP.

Here is consumption added to the same graph

FRED Graph

On one level this is obvious since consumption and investment are the main components of GDP. However, it could be the case that they are moving opposite yet the affect of investment swaps the moves in consumption. This doesn’t seem to be what happens. People consume less and invest less.

You could say that people should be engaging in more leisure instead of this consumption and investment. It is true that Aggregate Hours worked moves counter to all of these trends.

However, the loss in hours worked is related strongly to unemployment and people seem to dislike being unemployed. Few people comment that the problem with the boom is that I was working more than I should have and then I suddenly realized I should be taking time off.

Some economists have suggested this but it doesn’t resonate with what people actually experience.

So, we are left with the question: what malady is the Fed creating when it lowers the interest rate too much. It isn’t swapping investment for consumption and people seem to prefer working to not working.

My answer would be that if the Fed lowers too much it will generate inflation. That is the increase in what people try to buy will outstrip the increase in the amount people work. This will lead to people trying to purchase more goods and services than exist. When quantity demanded is greater than quantity supplied price will tend to rise to restore equilibrium. When this happens to all goods at roughly the same time we get inflation. [1]

Indeed, we see that inflation rises during booms and falls during recessions.

Here is inflation added to all of other trends

FRED Graph

The graph is getting crowded but I think its important to make the point that all of these things: GDP growth, Investment Growth, Consumption Growth, Price Growth all move together.

This is the basis for my claim – the standard claim – that the goal of monetary policy is to balance increases in inflation against increases in real growth. Indeed, on a deeper level we want to balance inflation against increases in unemployment.

Ultimately whether or not people want real growth in output or not is a personal choice. We could take all increases in productivity as leisure if we wanted. What’s bad is when people are looking for a job but cannot find one.

Now there are further questions about why there is unemployment in the first place. This is, of course not obvious from a basic supply and demand analysis. It is this question that mainstream macroeconomics tries to answer.

I sense that taking the conversation further is going to require discussion of the issue of asset bubbles. However, I’ll let Bob reply before going into that.


1 Economists like to think in real terms but I am speaking explicitly in nominal ones. There is a money price that people pay and it is this money price that can rise in all markets at the same time and it is nominal demand that can exceed nominal supply. However, this does still have to work its way through the goods markets. For the price of some good to rise the nominal demand for it must rise. We cannot have immaculate inflation. That is, contrary to what is sometimes asserted, the printing of money in-and-of-itself cannot cause inflation. Someone must use that money to attempt to buy something. The quantity demanded in that market must then exceed the quantity supplied. Only then can prices rise.