Russ Roberts

Cowen on Monetary Policy

EconTalk Episode with Tyler Cowen
Hosted by Russ Roberts
Marglin on Markets and Communi... Munger on Subsidies and Extern...

cowen.jpg Tyler Cowen of George Mason University and Marginal Revolution talks with EconTalk host Russ Roberts about money, inflation, the Federal Reserve and the gold standard. Cowen argues that alternatives to the current Federal Reserve system promise more risk than return.

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Podcast Highlights
0:36Intro. EconTalk survey thanks. Money, monetary policy, supply of money. What is the money supply and why do we keep track of it? Money used as medium of exchange. Different measures. Quantity is a rough indicator of extent of inflation, which has costs but in some special circumstances, benefits. Job of Federal Reserve (Fed) is to judiciously manage those costs and benefits. Inflation. If we just left the nominal quantity of money the same, what would happen? We could fix the monetary base, which is supply of currency plus bank reserves held at the Fed. Some broader measures of the money supply probably would grow through supply of credit. Nevertheless, since more goods and services would be produced, there would be deflation--price level would fall. Advantage: we would see in a transparent way the growth of the economy. But economists have argued that that's a bad idea. Friedman argued for stable prices, Fed increases money supply at roughly the same rate as growth in the economy. Human irrationality: Employees don't like hearing that their wages will be cut by 3% this year but that the price level will also fall by that much or even more. These are our current expectations, which won't go away soon. Don't want to have the wages of a large number of people have to fall. Larry Summers. With small amount of inflation, wage rises even though price level rises by more, so tricks people into being satisfied with their wages. Historical issue of variability. Want to try to distinguish between nominal and real changes. If inflation is unpredictable and uncertain you can't distinguish if your product's price is higher because of increase in demand or because of inflation. So economists have tended to argue in favor of low but stable inflation. Business investment decisions tend to be made for large rates of return relative to small rates of inflation.
9:16Fed, Central Bank. Standard macroeconomic argument for how a change in Fed policy will ripple its way to higher prices. Simple version: More money in the system, people spend or lend more, greater flow of purchasing power, and over time prices rise. Pretty clearly is true. More complicated version: What Fed is really doing is buying up Treasury Bills with cash. From the point of view of a bank, why is a cash holding different from a Treasury Bill holding? Different for tips in coffee shop, but not for financial institution. But they have different effects on the economy. Why? Friedman used to use idea of a helicopter drop, mental experiment. Experiment Number 1: Fed adds money to the system--say, it doubles the money supply--and people find they have more green pieces of paper, higher liquidity than they want, so they try to spend it. But no more stuff available than before, so price level doubles as people bid for the goods. Other version, experiment Number 2: the stores that find people trying to spend money find themselves with more money, and then think their goods are more popular; hire more people, produce more. In this version, real effects; but they are temporary. Eventually people catch on, businesses fire the extra people. If everyone knows the government is doubling the money or just adding zeros to bills, they are not fooled and there are no real effects. Monetary surprise can only work now and then. If there is unemployment and no one expects monetary increase, then the economy can be "stimulated" but it's temporary. (Or with strong minimum wages as in some of Europe.) If you try to play this game too often, you end up with lots of inflation and no increase in employment. This is what is going on now in U.S. Stagflation, thought to be impossible; Phillips Curve, idea that in the short run you can increase inflation and decrease unemployment. Doesn't mean you should inflate, but the grab bag option is there. It's not a universally exploitable idea. In 1970s, it didn't work--high inflation and high unemployment; money supply could not be used to manipulate the employment rate. With a real shock, monetary policy typically doesn't do very well. In the 1970s, the Fed first tried to deflate; then tried to inflate.
17:47Today we have another kind of real shock, collapse of real estate bubble. A good rule of thumb is that with a real shock, there is nothing the Fed can do. But is the real estate bubble a real shock or is it a nominal shock? Isn't the housing situation just a nominal change to an asset price? Shock to credit. Risky assets were thought to not be risky, but they've decided they were risky. Readjustment of asset portfolios is real, not nominal. But will there really be a shrinking of credit because of the lack of transparency? Sectoral reallocation away from risky assets. Global savings not down, just not funding risk. Bumpy path. Why trading in so many assets has dried up is the fundamental price. You'd think there still would be some price at which even junk bonds would trade. Price signals have been removed from the market and people don't know what to do. Agency problem. Pulls information out of market prices. Have markets, but don't have as much information injected into the markets.
22:28Fed. Open market operations, buying and selling of Treasuries. All the focus today is on the rate that the Fed charges member banks. By changing the interest rate, they are either encouraging (by lowering the rate) or discouraging (by raising it) member banks to borrow. Banks use the Fed as a lender of last resort. Is the Fed trying to affect bank costs or interest rates? Discount rate vs. Federal Funds rate. Fed admits discount rate--rate to lend to a bank in distress--is not effective. Term auction facility set up to bypass discount window. Federal Funds rate is what newspapers are talking about. It does that by buying more T-bills, which creates more liquid money, more available loanable funds, which pushes down the (short term) Federal Funds rate. Fed can't lower long term rate (or maybe by only a tiny amount), though it can through inflation raise them. Irving Fisher broke interest rates into real and nominal parts: productivity of the loan in real terms, what would grow; and the nominal part, the part that's due to inflation. If everyone expects inflation to be 10% per year, I'll never loan money at less than 10%. Inflation premium is built into interest rates. Leads to a paradox: Normally we think of supply and demand of money as lowering interest rates when we expand the supply of money. The interest rate is something like the price of money. But if the Fed puts money into the system, it will actually raise the nominal interest rate via inflation. Inevitable tension. If the Fed only does it once they can lower the real rate without the higher nominal rate; but if you keep on doing it you end up with high nominal rate. With a high nominal rate you also end up with greater uncertainty, greater variability. Some people have a low and others a high real rate.
31:18When we read that the Fed has raised interest rates (the Federal Funds rate), what has actually happened is that the Fed has intervened in the market for Treasuries. Often talked about through a different mechanism. The press often says things like "The economy is growing too quickly. The Fed is raising rates to try to slow the economy down. If interest rates are higher, people will invest less, take fewer risks. Now, they are worried the economy is slowing down, so they are stimulating the economy by lowering interest rates, trying to influence investment decisions." But that is not what the Fed is trying to do, is it? Complicated. Hard to show that higher or lower real interest rates actually have any effect on investment. If you are aiming for a 30% return on investment (likely will result in smaller rate of return after including failures), small changes in interest rates may have little effect on you. How credit markets perceive risk, framing of credit risk, psychological contagion effect; may be where a lot of where the Fed's influence comes from. Stock market often reacts strongly to the Fed. Information gained from what the Fed does. Behavioral economics: lending, risk perception, banks.
36:26Alternatives to the Fed. Some people think the Fed is harmful to the economy. Macroeconomic variability in the United States has become much smaller than 50 or 100 years ago, maybe because of Fed's performance (even though it's made many mistakes). What about private money or the gold standard? Throughout most of world history central banks have mostly been a disaster but in the last years worldwide they have done a good job. Mexican central bank example. Financial markets may have the ability to monitor central banks better than previously. Politicians showed that policies against inflation are popular, Reagan, Thatcher, Volker. Should we have free banking? Imagine that we had American Express Travelers' Checks as money, competing with Thomas Cook's Travelers' Checks. Risk. But what would advantage be? Right now we have something that looks like private money--credit cards. How would private money work in today's world? Is it legal? My bank check right now is a form of private money. Works because we have deposit insurance, so even if the bank had a problem my check would still be good. Private company could issue the money; what makes the difference is what kind of guarantee is behind it all. Colorful money, athlete faces, attractive women, trading cards. Why don't we have such money now? Originally governments wanted to earn seignorage, printing money and buying up services getting something for nothing, like a counterfeiter. Seignorage is no longer an important source of revenue in most countries. Government is loathe to give up something it has a claim on doing. Two functions of money: unit of account, and medium of exchange. Private monies are not legal tender--we can't force others to accept them. Currency swaps in foreign currencies. Economies of scale to liquidity.
44:15Because the currency value is not kept up with a regimented amount of gold, some argue that the whole thing is a house of cards. No backing. If you feel they are a sham, I'd be happy to accept them and sell you some services in return. Gold standard argument: some psychological. Some believe price level will be more stable and there would be fewer business cycles because the supply of gold is pretty stable. Slower to mine it than to print paper money. But look at the price of gold--it's very volatile. On a gold standard, the price level would thus be volatile. Would work best if all countries were on it. Is price of gold erratic mostly because it's speculative? Gold is a hedge against bad times and also against bad fiat (paper) money performance. Why take the chance? Why is gold a hedge against risk? True empirically. Russian ruble example, wallpaper. Why would you turn to gold? It's just a piece of metal. It's become a norm, but it's kind of no more reliable than fiat money. No necessary reason for that. Psychology. Historically, small amounts were quite valuable, you could hide or store it and it would be worth a lot. May not apply in today's world. Diamonds: little, associated with promises kept. On gold standard, more swings in a downward direction; greater chance of negative monetary shock with a gold standard. Great Depression and monetary shock. Could argue that gold standard could possibly do as well as we do now. Transition question: what is the right price of gold? If we make a transition at the wrong rate there would be a sudden inflation or deflation, and we'd give up on it.
54:34Independence of the Fed. Political economy: Is it plausible to think that the stabilities will persist in the next 25 years? New Zealand has Central Bank that is required to have inflation per the legislature, stable. Friedman podcast, attributed improvement in N.Z. performance to Donald Brash. Brash took over in 1989; by 1992 Act in full swing. Fed independence is something of a misnomer. They track public opinion. Supreme Court: political forces do matter and behavior appears to be responsive. Friedman's prescriptive rule for monetary growth idea has been abandoned (originally 3% per year handled by a computer), early 1980s. One problem: which money supply? But also, perception that if you freeze rate of growth of money supply, could have short term interest rate or exchange rate volatility would be unacceptable. Swiss example, ended up in price growth rules instead of monetary growth rules. Big learning process, 1980s. Focus on the outcome rather than on the tool. Maybe because the Fed can't really control "the" money supply. Independence: Fed's mandate is not only to control inflation, but also to achieve a stable "economy." But they do not have enough instruments to do this.
1:04:50Added material: Lawrence White CEE article on private money. Don Brash's effect revisited: inflation targeting rather than money supply targeting. Friedman's claim is that the way to hit that target is to pay attention to the money supply, not interest rates. Fed and M2, smoothness of growth of M2 is the key to our economic stability. Friedman argued that Fed was very aware of that and targeting money supply even when they say they are targeting interest rates. Next week, Munger on subsidies.

COMMENTS (69 to date)
Person writes:

Another week wasted. Yet another terrible interview.

Never underestimate the tendency of a libertarian to sell-out liberty. Friedman and Sowell hate immigrants. The woman at Cato who discovered that Iran is the only country not to have an organ shortage because they allow organ trade wants it here but with different restrictions on liberty. Now, this guy, supposedly a monetary expert and a libertarian by implication (I really could care less to look into this person's "work" or viewpoints), is against Free Banking.

Also, his submission that private money can exist under the current US legal structure is wrong. For an expert, he's woefully short on facts. Did the National Bank Act tax get repealed? Did I miss a meeting? Maybe he should go talk to the Liberty Dollar crowd. The FBI wasn't too impressed with their operations.

[Remainder of comment edited for rudeness--Econlib Ed.]

One question that I have never heard adequately answered from any economist is: who gets the money when the fed increases the money supply?

Obviously if it was seignorage the government would get the money. If it was literally throwing money out of a helicopter, whoever picks it up would benefit. If it was a pure revaluation, money would be given out in exact proportion to its current distribution, and the process would be completely neutral.

My best guess is that the Fed is subsidizing maturity mismatching. The losers are people holding cash and long term lenders. The winners are borrowers and short term lenders. The rational thing to do in this situation is to either borrow or put your money in assets. This distorts the economy and causes bubbles.

I was also under the impression that growth in M3 is the real number to watch - not price inflation or M2 ( actually, the right number is M3 minus time deposits). M3 has grown at 10% a year. This is far higher than most people realize, and it indicates terrible management of the money supply.

The smart Goldbug's don't buy goal because they think it's "real". They believe that if a government mismanages its money supply, there can be a currency run to a stronger currency. Historically, this currency is usually either gold or the currency of a large economy that's not mismanaging its money supply. Gold's price flucuates massively with the probability of currency run. If the Fed pulls a Volcker and tightens the money supply, the price will collapse back down to its industrial price of less than $100 an ounce. If the Fed inflates too much, we could see a currency run and the price skyrocketing to > $10,000 an ounce. You can see the price of gold as essentially being probability that the dollar will collapse.

B-rad writes:

Thanks for the podcast. This is certainly timely, and helps me to keep up with econ since graduating.

Ajay writes:

Patrick, I think your initial paragraphs are probably correct but I think your gold quibble in the last paragraph may be misguided. Russ and Tyler were not questioning the use of gold as a hedge but any mooted transition back to a gold standard. I myself favor asset-backed currencies but not the gold standard, so I think there are elements of truth to both what the goldbugs and the fiatists say.

Mark Koyama writes:

Great podcast. This was really insightful and I learnt a lot from Tyler's perspective on the role of risk and credit instruments. Thanks

Vlad writes:

I have a question: Isn't the current economic situation the sort of "crucial experiment" (to the extent that such things exist) required to set apart Milton Friedman's theory from Mises-Hayek theory of the business cycle?

Here's what I mean, oversimplifying things to get the point across: A recession is when, for some reason, it "happens" that a lot of investments turn out to be malinvestments en masse. Friedman's theory claims that this is just a random fluctuation (it's inevitable that such things happen from time to time), or that they are perhaps the result of investors (or sponsors of investments) aping each other in the wrong direction. Mises-Hayek theory claims that a large enough recession is such an unlikely coincidence that it requires a proper *cause*. According to them the cause is the Central Bank's expansion of the money supply which has the effect (besides inflation) of lowering the interests rates. Lower interest rates means that more people will be willing to borrow money, in part to pay for riskier investments (which now sound more appealing, given the low interest rates). Thus the Central Bank's policy of monetary expansion favors a greater number of riskier economic adventures, for many of which there is no real demand on the market, and of which many will eventually fail. And when a large number of them all fail simultaneously we have a recession.

Those two theories don't necessarily contradict each other, they could be seen as complementary; the question is which factors are the most important. (As far as I know, neither Mises nor Hayek claimed that their theory covered everything there is to be said about the business cycle.)

The problem is that the two theories warrant two entirely different plans of action. If Friedman et al are right, the Central Bank can adopt an active stance for taking the country out of recession quicker. The banks that sponsored the malinvestments lose, and this amounts to monetary destruction, so the Central Bank has to intervene printing money to replace the lost money. On the other hand, if Mises and Hayek are right, the last thing the Central Bank should do in a recession is to do anything. The recession is caused by the fact that there is no real market demand for the failed lines of business (the malinvestments), and we'll be out of recession only when the still working parts of the economy expand and absorb the labor now engaged in the failed parts. Anything the Central Bank does to help the failed lines of business or their sponsors (like pumping newly printed money into them) only deepens the recession and postpones the economic recovery.

Now, the Fed did exactly what Friedman advised, and things got worse rather than better. So, doesn't this mean that Mises and Hayek were right?


Wouldn't asset backed currencies create distortions? Imagine you had oil as part of your assets. If the oil price peg wasn't exactly at the natural market price, people could print money by drilling oil. If a new invention - say efficient solar - decreased demand for oil, how would this get reflected in the oil price if the price is fixed?

I kind of see gold as a fiat currency that has the natural property of government not being able to print more of it. The same result could be achieved by a constitutional amendment fixing the money supply.


Because of a bunch of complications, it's unlikely that we'll get a good answer.

First, it's difficult to determine the difference between illiquid and insolvent. Take a bank run. If people perceive that a bank possesses bad investments, they might start pulling their money. This will cause the rest of the herd to pull their money - money which the bank does not have in liquid form - and the bank faces possible collapse. If the underlying investments are actually sound, then the proper answer is to loan the bank a bit of liquidity to get through the crisis. Adopting an Austrian policy would force a collapse where it really was not necessary.

Of course, under Austrian policies, fractional reserve banking would be eliminated and liquidity crises would be very rare. But given that we do allow fractional reserve banking and we do have liquidity crises, an Austrian cure can create needless destruction.

If the investments are actually bad then the Austrian cure is correct and the only way to recover. The Monetarist cure will make things worse. Of course, the way in which it makes things worse might not be clear. For instance, the government could use heavy handed efforts to prop up housing prices even as it raised interest rates to combat inflation. This might prevent a recession and stagflation. However, our standard of living would decline as rents and mortgage payments for new home purchases became far more expensive. Instead of a short, sharp recession, you'd have years of less than normal living standard increases. The monetarists might declare victory for averting a disaster, but in reality we would have better off with a more Austrian response.

Martin Brock writes:

Discount Rate - The rate at which the Fed itself extends credit to member banks. The Fed establishes this rate and creates money to lend at this rate.

Federal Funds Rate - The rate at which member banks extend credit to one another. Member banks need not lend to one another at an established rate, so the Fed doesn't set this rate. It targets an average through open market operations.

In open market operations, the Fed buys or sells short-term Treasury securities (T-bills). These operations affect the Fed Funds Rate, because banks keep much of their liquidity either in T-bills or as short-term deposits in other banks.

To lower the Fed Funds Rate, the Fed buys T-bills, bidding up the price of the bills and lowering their yield. Since it may create money for this purpose, the Fed may pay any price for the bills. Banks respond by selling T-bills and making deposits in other banks at a slightly higher rate. This slightly higher rate (higher than the nominally riskless T-bill rate) is nonetheless lower than the rate at which banks previously lent to one another, so the Fed Funds Rate falls. Since this operation increases liquidity in the banking system (money not parked in T-bills), it can increase lending.

Typically, the Fed Funds Rate is lower than the Discount Rate. If I show up at the discount window asking for credit, then I've already exhausted my credit with other banks, so the Fed knows my credit is poor and will scrutinize me.

I think the show emphasized too little what "money" is. When we say "the Fed creates money", we mean "the Fed extends credit". Credit is essentially an advance on my future production. I have nothing to sell today, but if I can avoid starvation for the next six months, I can produce something and sell it for more than the cost of avoiding starvation. Maybe I can earn income transporting goods from place to place, but I have no money to buy gasoline for my truck. I need you to pay me in advance, so I can buy the gasoline.

Money (currency) is an entitlement to consume goods currently. Credit accounts for the expected value of future production. I exchange my expected future produce for a right to consume currently. You credit me for goods I haven't produced yet but expect to produce. We must create money for this purpose, but money is only an accounting device. An expanding "money supply" only reflects the expectation of an expanding volume of goods produced.

Could the Fed have avoided the depression by "printing lots of money"? Maybe it could have, but this expression doesn't describe the process well. The Fed might have avoided the depression by extending lots of credit, by recognizing that many idle factors could organize themselves more productively if entitled to consume more currently.

I'm skeptical of this presumption, because it ignores the role of statutory monopolies. Extending credit doesn't help me if law effectively forbids my productivity by forbidding me to compete. Refusing to extend me credit is one means of forbidding me to compete, but it's hardly the only means. States are all about forbidding competition in various ways, for better or for worse.

Gary Rogers writes:

This was a very timely subject and you presented it well. I agree that this topic is not well understood even by economists, but it is something we must get right if we are going to avoid lots of trouble in the future. Here are some things that I THINK I understand about monetary policy that might add to the discussion.

Banks constantly create money through fractional reserve lending. My understanding is that another tool the Federal Reserve has for controlling money supply is to adjust the reserve requirements banks must maintain. Increasing the required reserves prevents banks from creating as many loans and thus decreases the money supply. I cannot remember this being used in recent history, but it is one of the available tools.

People and organizations can and do voluntarily remove money from the money supply. This is why shocks to the economy cause markets to lose liquidity and the Fed needs to intervene. The money is still there, but people who are unsure of the future will hold on to whatever money they have until they feel it is safe to spend again. Lost confidence, high interest rates or deflating currency cause people to hold onto their money. Low interest rates, inflation and confidence cause people to spend rather than save and the money is returned to the money supply. This is something that was not recognized in 1929, but has been handled well ever since.

One major influence on money supply that should not be ignored is the three trillion dollars of Federal spending every year. All federal spending is added to the money supply and taxes are removed. Deficits mean the Fed needs to deal with the inflation. They can simply print money and allow the inflation, they can print money but raise interest rates to encourage people and businesses to voluntarily pull money from the money supply or they can sell bonds to cover the deficit. Politicians love the third option because it pushes the problems into the future and allows them to continue stimulating the economy with low interest rates and low taxes. I am convinced that our continued addiction to deficit spending and selling the debt overseas has kept our economy surprisingly stable for the last thirty years, but has been the reason for our trade deficit and is now the underlying reason for the weak dollar.

You questioned whether other currencies could be used and it is worth remembering that several towns and banks created their own currencies during the depression. This was out of necessity and shows the severe lack of money when it was needed.

I do not think you gave enough credit to the argument that governments have a long history of mismanaging their currency. Gold is more volatile and traders try to manipulate the market, but it is always marketable. When I look at what economists and politicians are saying about our weak dollar and the solutions they propose, how can you not consider gold as an alternative? It comes down to governments not understanding monetary policy.

Jeremy Weltman writes:

Another interesting podcast and review of my undergrad and postgrad monetary economics (always useful to refresh my memory as I get a little older!). Your discussion was obviously US-focused, but it may be worth reflecting on European experience (by the way the European central banks have some interesting differences in approach - they do not all behave the same). The following points may be of interest.
1. In the UK we tried monetary targeting - focusing on Sterling M3 and "little Mo", a narrower base money measure - (the great Thatcher experiment) and it failed catastrophically.
2. Following the successful New Zealand inflation targeting approach the Riksbank (Sweden's central bank) copied the approach and also made it work.
3. This was because of many other added features to improve the transparency and operational efficiency of monetary policy, which you didn't mention (and that may be because the Fed operates differently - I'm no expert on the Fed; this is from memory).

First, the Riksbank has declared a low inflation target (2%). It targets an underlying measure of inflation. Certain other central banks target 2.5%.

It (and other European central banks) have improved their independence; an independent policy board is elected with equal votes (in the case of the Bank of England - only in the event of a tied vote does the Governor's vote really count - I believe this is different to the Bernanke/Greenspan approach).
The Riskbank/Bank of England etc publish the minutes of their meetings so that economic agents can see how Board members decide. The dates of the policy meetings are also published in advance.
Regular Monetary Policy reports are published (3-4 times per year), including detailed fan charts showing likely paths for interest rates and inflation.
In fact, it is a lesser known fact that Norges Bank (the Norwegian central bank) has started to, in a sense, 'pre-announce' its interest rate decisions using this forward-looking path approach (ie. it can be inferred how many increases in interest rates are expected and when they might peak - it isnt a perfect science but it helps), thus making a firm signal to the money markets and economic actors; this provides useful information and is consistent with the rational expectations approach.
There is also some debate at the moment about whether monetary policy actually works at all for some economies; Iceland, for example, - it's a small country I know, but it has had a major shock with massive aluminium investments and an opening up of its mortgage market - more competition for the state-owned housing finance fund; consequently interest rates have risen sharply but this has not been reflected in money market rates, so inflation has also risen sharply and monetary policy has not worked - an interesting comparison test case.

I look forward to some more podcasts on the subject.

Ian Lippert writes:

Could someone explain to me why mild deflation would be a bad thing? He claimed that it would put downward pressure on wages and that this would be politically untenable.

But I dont really see how falling prices neccessarily equate to falling nominal wages also. If the profit margins are staying the same and labour isnt generally willing to take a pay cut, cant prices fall while wages stay the same?

If it is true, a simple change in psychology of the labour force could accomodate deflationary pressures. I work part time at a seasonal job, and my hours fluctuate over the year. I dont get this need for 40 hours or nothing. So mabey I lose an hour every 5 years or something. Or mabey companies simply decide to count the rate of deflation as your yearly raise. Since companies often are forced to give you a raise above the inflation rate.

I really dont understand this irrational fear of mild deflation. Can economists really not tell the difference between a deflationary shock caused by the bust of an artificial boom and the predictable mild deflation of a productive economy?

Carl Jakobsson writes:

Thanks for an interesting podcast!

I just want to say that there was one argument for the goldstandard that wasn't considered: it could be an international currency, eliminating exchange-rate risk (or the costly futures market in currency) and thus strenghtening the international division of labor. From my perspective - I'm from Sweden, with a tiny market of about 9 million people - it seems an incredible waste to have different currencies.

And I'm a little sceptic about Cowen's remark that the it would be very bad if one country would go one the gold standard. What about England in the middle of the 19th century? After a while some more countries followed, but before they did, did England's economy really suffer in any way? Or would it be different in today's world?

And it seems that is not entirely possible to create your own private currency in the US:

Russ Wood writes:

Tyler and the listeners should read today's (Tuesday) WSJ Op-ed by Reuven Brenner (whom I suggested for a guest on EconTalk several times). He adds what Tyler omits. Money is an unit of account and therefore fuctions best with a stable value or anchor. Even Tyler's 1%-3% inflation preference wreaks massive havok over time.

Also, my respect for Freidman increased dramatically when, late in life, he admitted his monetarism was flawed. Russ and Tyler seemed to have missed that omission.

Carl Jakobsson writes:

In what way did he say it was flawed?

John S. writes:

Very interesting podcast as usual. One of the things I took away from it was that so many of the aspects of money and banking that seem mysterious to the general public are just as mysterious to economists.

I especially liked Cowen's reply when you asked him what he would do about the current subprime crisis: "I don't know." If only more politicians were honest enough to say that.

In the future I hope you can find someone to explain the even more complicated subject of exchange rates. Why is the dollar falling against the euro, and is this something we should be concerned about?

John S. writes:

One more comment Russ: there are apparently a lot of local currencies in various parts of the country. See this article:

Thanks to Russ Roberts for his impressive work and his most interesting podcasts making economics accessible to a wide audience. However in his endeavour to defend the FED’s monetary policy and our crumbling monetary system, Tyler Cowen here “forgets” a number of aspects and even tells some obvious fallacies :

1. Mr Cowen’s starting point to consider the housing bubble as an external cause to the present financial crisis is a clear fallacy. It was indeed the FED’s monetary policy and its easy money and cheap credit which caused the present housing & banking bubble and over-indebtness in the first place.

2. The FED certainly has NOT done the “reasonable good job” claimed in this podcast. During the last century inflation was the highest ever recorded. The US$ lost 95% of its 1913 buying power. The inflationary policy of the FED was also the direct cause of an accelerating number of asset bubbles (including the 1929 depression). Each of these bubbles caused large numbers of bona fide victims (who were fooled by the illusionary wealth of paper money) such as the couple of million foreclosed homeowners in the present crisis. (see :

3. The inflation caused by the FED’s excessive money printing is not socially neutral. It causes a redistribution of wealth from private citizens to the bank sector. The purchasing power the banking sector acquires by means of excessive money printing is purchasing power which is diluted from the people's buying power they have worked so hard for. Inflation so causes a real impoverishment of hard working people. The Fed’s actual m3 money supply rate of ±14% is nothing less than legalised counterfeiting benefiting only the bank sector.

4. INFLATION TARGETING IS A CONCEPTUAL ECONOMICAL INCONSISTENCY. The detrimental consequence of targeting inflation is that the average price level cannot decline. As a result the price mechanism is incapacitated. Inflation targeting prevents prices from easing and people’s buying power from rising when productivity increases. Increased productivity results in lower production costs and targeting inflation even at the “moderate” rate of 2-3% prevents these productivity gains from benefiting the consumer, and therefore means nothing less than institutionalised confiscation by the bank sector of prosperity gains resulting from progress. Moreover the self healing effect of price reductions during economic downturns is lost.

As long as the gold-backed money standard is not restored only targeting the money supply at the growth rate of the real economy can provide price stability and allow purchase power to keep up with productivity. Any growth rate above this rhythm is inflationary in the true sense and is jeopardizing the economy.

5. It is a fallacy to associate deflation ( lowering prices ) with a depression (or a business downturn) which must therefore be avoided by all means. Easing prices in the early stages of a slowdown are on the contrary the beneficial remedy to restore people’s REAL buying power after long periods of inflation. Therefore it has no sense to fight such deflation as the increased buying power resulting from such deflation has the healing effect of ultimately boosting demand in REAL terms.

6. Easy money policy and negative interest rates in particular do not only cause over-indebtness and asset bubbles, but most importantly slow down saving, whereas saving (accumulation of capital) is the sole source of non-inflationary progress through investment and REAL increase of productivity.

7. Claiming a gold standard would increase price volatility by referring to the recent gold price volatility and 1000$ gold is a fallacy. The volatility of the US$/gold ratio is not a reflection of a rising gold price but of a falling dollar. Prices of most basic commodities such as oil and food are nearly flat when expressed in gold value. It is the FED’s excessive money printing which causes the US$ to fall. Therefore the gold-standard would decrease rather than increase price volatility of raw materials as well as for consumer goods.

Norm writes:

Russ, another great podcast.

I am not an economist nor do I have formal economic training. Its fascinating to see the very emotional opinions expressed in the comments about what I would think are very arcane issues.

A couple basic questions:

You said that if inflation is 10% then that sets the base interest rate that you will charge to loan your money at 10%. This assumes that there are an unlimited supply of borrowers. Doesn't lending and borrowing follow a supply/demand relationship? Sitting on your money loses you 10%. Lending at 5% is better than 0%. I have always imagined that waking up one morning to find I am the manager of the Saudi oil wealth and have a trillion dollars to invest would be deeply frightening. Where can I find all the borrowers I need, qualify them, track my loans, etc. I may have to compete to find borrowers and I may have to offer lower rates to win them over. Are not there huge amounts of savings in the world looking for safe borrowers?

I am still unclear on the concept of the Fed creating money. I have always thought that when the government spends money it either uses the money collected as taxes or sells T-bills to get the money to spend. Is this incorrect? This would not involve creating money just transferring it. The Fed interbank rate covers money loaned from on bank to another. No creation there either. You said no one uses the discount window, so even if it could create money, it doesn't. I am confused.

Ajay writes:

Patrick, what currency doesn't create "distortions"? There were profoundly inflationary periods under the gold standard when large supplies of gold were discovered. Who says asset-backed currencies would have to used fixed pegs? You could just use the market prices. Yes, that means the value of the currency you hold fluctuates everyday. Guess what? It fluctuates currently when you hold it in a checking account or cash, constantly devaluing according to the rate of inflation. I would be fine with fixing the money supply too, though I think asset-based currencies have potential beneficial information transmission effects.

Norm, what you don't seem to understand is that the Fed is the Federal Reserve, not the Federal Government. The Federal Reserve is an independent central bank that has some governors appointed by the President. They print money according to inflation-targeting principles, the Dollars you hold are printed by them and are called Federal Reserve Notes. You can read more about them here.

Martin Brock writes:


I had the same thought about the 10% inflation expectation and real interest rates, but if the inflation rate is 10%, then by definition, I can buy a durable commodity, like gold or diamonds or something, and expect the price to rise 10% over a period, so if I'm strictly a rational profit maximizer, I won't invest at a lower expected yield. Of course, we aren't strictly rational profit maximizers, and we don't know things like the inflation rate in the future, and "general inflation" doesn't exist since different prices rise at different rates, but if we take the assumptions for granted, I suppose Roberts is right.

Yes, the government either taxes or sells Treasury securities to raise revenue, but the Federal Reserve itself buys Treasury securities and may create money to do it. When the Fed "lowers interest rates" (the Fed Funds Rate), it's buying these securities. When it "raises interest rates", it's selling the securities. See above. It buys the securities (from member banks) to add money to the banking system.

If the Fed holds a Treasury security, the Treasury effectively pays no interest on it, because the Fed's "profit" belongs to the Treasury. The Treasury routinely recycles its debt, so it can sell the Fed a note today and repay the note tomorrow by selling the Fed another note. Insofar as the Treasury and the Fed cooperate this way, the Treasury effectively creates money and spends it with no real requirement to repay it or to pay any interest on it.

The Fed may sell the notes it holds, thus drawing money out of the banking system and "raising interest rates". When it does, the Treasury's interest costs increase. In this scenario, the Treasury pays interest to member banks rather than effectively paying the interest to itself and also pays a higher rate on short term securities.

Martin Brock writes:

Correction: The Fed need not buy T-bills directly from member banks when "lowering interest rates" in open market operations (though it may). To have the desired effect on interbank lending, the Fed only needs to lower the interest rate on these bills, so banks will choose more to lend to other banks rather than buying the bills.

Jon writes:

Cowen (8:14): "..under price stability a lot of particular prices are moving, and you're never so sure why."

How are prices moving more under price stability as opposed to price inflation? And if prices are truly stable then when one particular price is moving, doesn't a firm then have a better way of finding what part of their business is affected by this change in price? Wouldn't this be more efficient for the firm thus making better investment decisions and allocations of capital?

Unit writes:

I'm glad Russ was slightly unprepared, it slowed the rhythm down for us novices. I tend to like Tyler's position, except when he says that we shouldn't try deflation because people's irrationality would lead them to reject it. My worry is that the same "irrationality" argument could be applied in other situations where market solutions are proposed.

This said, it's true that the problem with deflation is probably due to the way our brains are wired. If prices start to go down, there is an obvious lower bound: zero. After a while one would have to start using numbers that start out with 0.00000etc... of course in the logarithmic scale getting close to zero in negative multiples of ten is the same as going to infinity with positive powers of ten. But most people's bias and intuition is with the large scale, not the infinitesimally small.

John S. writes:

When I read Paul Vreyman's statement above that "prices of most basic commodities such as oil and food are nearly flat when expressed in gold value" I was skeptical. Since time series data for both oil and gold prices are readily available on the internet, the assertion is easily checked.

Mr. Vreymans, I think you should download the data for yourself and see whether you stand by your original statement.

Jon writes:

John S,

See the chart here at WSJ online: Oil and the Dollar

Unit writes:

Sorry I meant to say "getting close to zero with negative [powers] of ten...", not multiples.

Russ Wood writes:

Carl Jakobsson wrote:
In what way did he say it was flawed?


Russ Wood writes:

Podcast: Money used as medium of exchange.

Reality: Money's role as a unit of account is much more important. Suppose Cowen and Roberts are stranded on a deserted island. Cowen learns to catch fish and Roberts becomes adept at gathering pineapples. Money won't increase trade (over barter) in this case because both items are perishable and the production and storage times are very short. Back in civilization, Cowen's son bakes bread while Roberts' son makes wine. Here money can increase trade over barter. The bread can be made in one day, once the ingredients are on hand. The vinter requires time, often years, for production. If Roberts and Cowen trade via barter, trade is limited by time contraints. If they trade using money, Cowen Jr. can deliver the bread for a year in exchange for an agreed upon amount of money. At the end of the year, he can return the money to Roberts when the wine is ready. BUT WHAT IF THE VALUE OF MONEY HAS CHANGED DURING THE YEAR? The money here is not a medium of exchange but a store of value (X loaves of bread or Y bottles of wine, etc).

Russ Wood writes:

Tyler shows a very good conventional grasp of the money supply. But what about demand? If this were a discussion of oil, there would be discussion of both supply and demand factors.

Money is no different.

The quanitity of money (supply) can be constant and yet we can experience deflation or inflation or price stability. If demand matches supply, we have stability. if demand exceeds supply, we experience deflation and vice versa. Any discussion of monetary policy must include both.

The Fed's job is to match supply, which they control, to the amount of money demanded by the economy. Of course, there is no perfect measure of money supply or demand, which is why the Fed steps in it so frequently. Fortunately, we have price signals that tell us when the supply of money is out of line with the demand for money. These signals, gold primarlly and other commodities as well, are screaming inflation.

Martin Brock writes:

As a unit of account, money is never a real store of value. If the banker wants a store of value, he may purchase a durable commodity with his currency, but the value of this commodity relative to the value of wine need not remain constant either.

Martin Brock writes:

If the baker wants ...

Stephen writes:


Aren't TIPS a much more stable store of value as the rate of return is close to constant in real terms? Commodities are not a stable store of value because the change in the price of commodities can be very different than the change of price of finished goods and services. Additionally, commodities have a storage cost associated with them.

John S. writes:

Jon, the WSJ chart begins in 2000. EIA has data available going back to 1986 (WTI Spot Price). I found monthly gold prices back to 1971 at I made the same plot as in the WSJ article, but with a starting point of January, 1986. On that basis, the price of a barrel of oil in ounces of gold is seen to be just as volatile as the price in dollars. Also the two series are clearly correlated -- when the price in dollars rises, the price in ounces of gold rises as well. It's only around September of 2003 that the two start to separate. This is also evident in the chart you cited from the WSJ.

I don't know what conclusions could be drawn if data were available even further back. But I wouldn't want to bet the farm on the gold standard based solely on what has happened since 2003.

Ramiro writes:

From a practitioner standpoint, interest rates do much of the same functions as money:

1) They serve are reference
2) They measure the cost of liquidity (through discounting)

So when I call my investors and offer them a new debt product, they automatically ask, what is the rate of return? Not the risk or NPV of the investment. In their mind they contrast the rate of return with the inflation at hand, (keep in mind that the country I live in has an undisclosed inflation of 20-25%). Why doesn't the investor care for other considerations? All business decisions in an inflationary period a short term, 3 years max; his chief problem is to maintain his savings/investments from depreciating.

As, the podcast, and as Fisher mentioned, the interest rate has a major effect on the decisions of investors, savers, and bank's balance sheets.

Farther away from a Behavioral Economics stand point, higher real (and nominal) interest rates will have an effect on how much cash there is on the street, what kind of goods are sold, what services are provided, etc. The psychological standpoint is relevant when there is speculation on interest rates, currency or gold prices, etc.

Paul Vreymans writes:

Dear John S.

Between 1965 and today oil price expressed in us$ went from from 2.92$/barril to 106 $/barril or a spread of 1 to 36.3 ( see )

During the same period the oil price expressed in gold ranged between 3.2 oz/100 barrels
to 12.4 oz/100 barrels or a spread of 1 to 3.87 ( see : )

Volatility of the oil price when expressed in $ proves to be nearly 10 times higher than if it were expressed in gold.

At the end of the podcast Mr Cowen fears increased volatility of raw material prices under a gold standard and uses this as an argument against the gold standard. History shows this is a fallacy.

However our main argument against the present monetary system was that targeting inflation even at the “moderate” rate of 2-3% prevents productivity gains (as a result of progress) from benefiting the consumer, and therefore means nothing less than institutionalised confiscation by the bank sector of prosperity gains resulting from progress. Also that targeting inflation incapacitates the price mechanism so that the self healing effect of price reductions during early stages of economic downturns is lost.

steven mcduffie writes:

Now, invite Walter Block on the show for the opposing view. In fact, I would love to hear Block debate Cowen on this issue.

Econtalk would be much improved if it was a debate show, with Roberts moderating.

Also, when are we going to hear a podcast on immigration?

Martin Brock writes:


TIPS are a stable store of value by fiat, but I'm a libertarian who hates fiat debt, so I hate TIPS too. It's not fiat money I hate. It's fiat debt. I don't want the state guaranteeing anyone a real yield, especially by raising taxes.

TIPS have huge costs associated with them. As an investor, you simply aren't required to bear the costs, because the state threatens to harm people who won't bear the costs for you. In fact, TIPS aren't "investments" at all in my lexicon. They're pure entitlement.

In principle, I can go along with a limited quantity of state borrowing as an instrument of monetary policy, so monetary authorities have something like gold to buy or sell to expand or contract the money supply. See above. These instruments don't properly involve any guaranteed yield above the rate of inflation. This guarantee defeats the purpose.

In 2000, Greenspan and Bush opposed the Gore proposal to pay off all privately held Treasury securities to prepare for the baby boom retirement, on the grounds that the Fed needs to trade a quantity of nominally riskless debt in open market operations to a conduct monetary policy. I went along with that. Boy was I a chump. The Bushtapo promptly went on a spending spree that put Lyndon Johnson to shame.

jp writes:

Russ, very ambitious of you to move econtalk into the tricky realm of monetary economics. I applaud you.

I like to eat while I listen to econtalk, and Cowen made me choke on my soup on a few occasions.

Minute 38: "the Fed has done a reasonably good job..."

As Paul Vreymans pointed out above, the US dollar has lost most of its purchasing power since the Fed was established in 1913. Good job? I don't think so. I used to buy comics for $1.00 - now they cost $4-$5.

Minute 40: "What makes the bank cheque work even though it is private is that we have deposit insurance."

Yes, Cowen is right that bank cheques are a form of private currency. But they have been used as currency long before the Federal Deposit Insurance Corporation (FDIC) was created to insure depositors at commercial banks. Even today Australia and New Zealand do not have deposit insurance schemes, but cheques continue to be accepted in those countries. Cowen is propogating the very un-Hayekian view that only governments can bring about the creation and management of currency through institutions like FDIC, whereas history shows it arises through spontaneous processes, and continues to do so in places like Australia.

And if deposit insurance is so important to Cowen, why can this not be provided by private insurers?

Minute 41: "Seignorage is no longer an important source of government revenue in most wealthy countries."

Each year the Fed earns some $35 billion in revenues. It takes out expenses, the other $29 billion or so being returned to the Federal Government. This is seignorage: a pure profit paid back to the government. The Federal budget runs around $2.9 trillion. That means seignorage accounts for around 1% of Federal spending, which would not be taken lightly by policy makers if it were taken away.

Russ, I hope you'll do more monetary econ podcasts. Free-bankers Lawrence White or George Selgin might provide a good counter-balance to Cowen, who is a strong believer in the Fed's current government paper money monopoly and other institutions like FDIC that interfere with the monetary system.

I think this tradition goes back to Friedman who, though he claimed to be a libertarian, was always pro-Federal Reserve. Indeed, most economists keenly criticize government interference in goods markets, infrastructure, international trade etc. but when it comes to the realm of money, government can suddenly do know wrong. Listening to Cowen, it is hard to pick out anything libertarian in what he has to say.

Thanks again for the podcast.

muirgeo writes:

Great podcast. I feel a little better about the Fed now but the agreement that money is infinitely complex and needs "managing" suggest the world and the economy is not as simple as some would like to claim it to be. How can we speak of a "free market" when its very first step, the money system, is so heavily in need of "planning"?

How we set up Fed policy matters greatly for the success of our economy and has great implications for how our economic success is shared.

We are seeing a major historical economic occurrence unravel before our eyes. I would like a talk SOON on how all the expert bankers, financial wizards, CEO's and fed administrators allowed us to get to this point.

I read an article in the St louis Post Dispatch by a retiring Fed Chair from there that blamed the fiasco on poor economic education of the American public. Needless to say it left me fuming.

Ajay writes:

muirgeo, I'd say he was right, particularly in your case. Is that why you were mad, because your ignorance was pointed out to you?

Skytreat writes:

You were talking about what would happen if different sources printed money, the "Why couldn't I start my own currancy?" question. I'm living in Hong Kong right now and the currency appears to be issued by different banks. I have a $50 bill from The Hongkong and Shanghai Banking Coporation on it and another $50 from Bank of China. I don't really know what's going on here but I thought it might be somewhat relevant...

Ruppert writes:

Thanks for the podcast Russ.

I'm not an economist, like both Roberts and Cowen, but I'm baffled by this podcast. So many pressing issues were either dealt with poorly or completely omitted.

How can you talk about monetary policy and not mention that the dollar has lost half of its value in the last 6 years? Or that it's worth pennies on the dollar compared to 1913?

What about mentioning that the Fed's cheap money (along with its regulatory blind eye) is the root cause of the sub-prime predatory lending folly - and the upcoming financial collapse?

What about mentioning that the Fed is a private institution? That the Whitehouse selects the Fed's chairman from a set of candidates pre-picked by the banks themselves?

If the Fed is so great at its job, how come we keep getting into recurrent bubble-bust cycles?

What about mentioning the Feds constant secrecy? It's bailout of any faltering bank such as Bear Sterns thus perpetuating the "privatize the profits and socialize the losses" mantra?

You didn't mention the Liberty Dollar.

Like a few other Econtalk podcasts, the main themes are maintaining the status-quo. You appropriately quote Irvin Fisher, because this is the sense I get here. We're on the bring of a massive financial collapse, and people are still pontificating about how great the Fed is or how the Fed can't do much to 'help' us through this crisis.

I guess only time well tell who's right here. Unfortunately, it's the little people that will pay dearly for these policies. Professional economists will continue being the useful apologists for the elite's class warfare.

phil writes:

Thanks for a great discussion.

Re: gold and/or diamonds as backing for currency.

1) Anyone who thinks gold can limit inflation should look at the history of Spain after conquistadors (thieves) started shipping large supplies of gold back to Spain. More gold showed up and more price inflation occurred.

2) Diamonds, unless you are in the business, are generally bought retail, and sold by individuals wholesale, with extemely wide bid/asked spreads. Just try getting back anywhere near the retail price for a diamond ring or earrings if you go to a diamond dealer.

On money:

Over time, all kinds of things have been used as money. It all depends on what people are willing to accept. For example, tobacco was used as a medium of exchange in Colonial North America. And, it often is used where other forms of money are not available -- prisons -- war zones -- etc.

Some Pacific Islands used large stones.

Isn't in the end, money whatever anyone is willing to accept as payment for goods or services? And, isn't the real strength of the US Dollar (green money) the productive capacity of the American economy?

And, shouldn't a discussion of money, interest rates, and inflation, also include some discussion of productivity and product improvements. If I produce 10% more with my labor then a 10% pay raise may not be inflationary.
If a new car is more fuel efficient, more comfortable, and safer, is a nominal price increase really inflationary. How about comparing prices to units of labor needed to purchase them rather than using nominal dollars?

Marcus writes:

In the discussion it is mentioned that the Fed when it adjusts the Federal Funds rate can't really affect long term interest rates.

Is that really still true? Today we have Structured Investment Vehicles which, essentially, sell short term bonds to buy long term bonds. Can't these financial vehicles provide a channel through which changes in the Federal Fund rate can more directly influence long term interest rates?

Doug Dillon writes:

Not bad at covering the very, very basics, but clearly both Russ and the guy his is interviewing are complete babes in the woods. I get a deeper, more insightful discussion of this stuff on the investment boards. Clearly the topic of "runs on a bank" and how this occurs in the modern derivatives world (which is what sunk Bear Sterns) was not touched on, nor the idea of counter party risk, nor the fact that increases in the money supply are being used to protect banks from insolvency by using inflation to transfer money from non-bankers to bankers.

Martin Brock writes:

Dollars don't have value. Dollars are a yardstick by which value is measured. We shorten the yardstick continually.


Yes, I'd like to see more discussion of this stuff.

Did Bear Sterns suffers a "run" (which sounds like an irrational reaction of investors), or were Bear Sterns' investments actually irrational? "Rational" here means "ratio-able". I'm asking a question about the relationship between the booked value of securities and the current value of assets secured. Since the bank's market value plummeted, I suppose the securities on its books didn't reflect valuable assets before the plunge. Does "run" suggest something else?

Apparently, Bear Sterns employees ("the bankers") will lose a bundle if the acquisition by J. P. Morgan occurs at $2/share, since employees reportedly hold 30% of Bear Sterns shares. On the other hand, employees presuambly bought these shares from their salaries in the past.

The people who really make out like bandits when a bank overextends credit are the people receiving the credit. Bank employees are among these people, since they pay themselves salaries to extend credit. They effectively extend credit to themselves, and this credit is only as good as the credit they extend to others.

If it's really all about subprime mortgages, then the people who occupied houses they couldn't afford also made out like bandits, even if they must leave the houses now; however, I doubt that it's all about subprime mortgages.

Ron Hardin writes:

1. Money is a ticket in line to say what the economy does next, presumably something for you. It is not, in particular, wealth.

2. The Fed creates and destroys tickets so that the outstanding tickets match what the economy is capable of doing at once.

3. The Fed uses leading indicators of inflation to judge whether to create or destroy tickets more than it's currently doing, or less. It has no particular interest in velocity or the size of the money supply, just whether it's creating or destroying too fast, just right, or not fast enough, according to its leading indicators.

4. It adds or subtracts a little more or a little less by lowering or raising its interest rate target a little. It buys debt or sells it until the economy responds by producing that interest rate as an output. The Fed using that output from the economy to judge whether it's adding or subtracting a little more or less according to the policy it's set for the month.

5. This method of adding tickets or taking them away distributes them across the economy is sort of a minimally disturbing way, in terms of influencing what activities get encouraged or discouraged.

6. Important : the Fed's leading indicators of inflation have to be pretty much orthogonal to the interest rate change, or the Fed would be blinded by its own intervention, in terms the leading indicators for the next meeting.

7. So the Fed is not free to intervene in just any old way, lest it lose track of future inflation by going blind. It runs some risk of this now. Its indicators won't work right for a while until the disturbance dies down.

8. Steady growth of the monetary base : if it's optimal, it will be an output of this process, not a controlling input to it.

jp writes:

Just listened to Russ's interview with Milton Friedman and would like to correct my earlier comment.

Friedman was not pro-Federal Reserve. In his younger days he was in favor of installing a computer in its place that automatically increased the money supply. In the interview he claims he would be in favor of keeping the high power money supply fixed. There is still an element of control though in his prescription, as opposed to a more Hayekian spontaneous solution. Cowen follows in the tradition of the former.

It's a good interview, by the way. I preferred it to this one.

Schepp writes:

Russ and Tyler, Thank you. Outstanding as ussual. If gold's value is by the value that individuals give it, included pyscological and heritage affects, Consider the following: My money is backed by gold. On any day I can exchange my money for the market value of gold. I could even call up all my friends and start using gold as curreny. Of course I will not because:

It cost more to use gold than money!

Gold has many risk, in terms of infation risk due to new discoveries of gold. Deflation risk is also there because growth of the economy may grow much faster than the supply of gold. Gold's heritage of a social contract may diminsih as well. Many people will also not acept gold because so many others will not either.

Inflation also has key role in our money supply it is indeed good for all that there is the market value of inflation, it charges a price to hold on to future promises without putting your money to work.

Monetary policies also compete. The Dollar competes with the yen, the euro, and the rest. People use the one that is most effective for them to use. If the US started implimenting inefficient policies compared to other currencies our money will be devalued and we the users will pay more in user fees or we will switch. We can switch to gold, silver, chickens or others. I am opposed to the term by fiat when it is used to just mean by whim. Money is a contract between the users of the currency they will be able to trade products with non-discrimination based on stable inflation. The governments commitment that your money will be able to redeam any product is done based on competition. Our desire to enter into this money social contract is also based on what is in our ownself interest.

paul vreymans writes:

In response to Phil and Shepp.

Under a gold standard the money (gold) supply is limited to whatever an economically be dug out of the ground. Except for a few rare exceptions in history ( Spanish coquistadores and the California gold discoveries ) this physical-economic limitation kept growth of the gold supply relatively small as compared to the available gold stock, and never lead to major inflation. Even during exceptional gold finds inflation was limited and NEVER caused run-away inflation or collapse of an economy.

Paper money standards however lead to numerous collapses. Under a Paper Standard there is no physical limit whatsoever to printing more money, and the only economical limitation is when the paper has more energetical value from burning it (such as at the end of the Weimar inflation) than it costs to produce the money.

Monetary history is indeed full of cases where governments debased their paper currency and produced an economical collapse to finance wars or to fund crook dictatorships: Napoleon’s Assignats, Weimar Inflation in the early 20ies, the Argentinean collapse in the early nineties and even today in Zimbabwe….

Mr Shepp fear for lowering prices during deflation is mistaken. What is indeed wrong about computers only costing us 20% of what they costed 30 years ago? Did falling prices reduce employment, profits or consumer satisfaction in the computer business ? Certainly NOT so: Lowering prices only increased consumer’s buying power and give birth to a flourishing new branch of industry making knowledge and communication accessible for the whole world.

DEFLATION IS A GOOD THING, and in fact the natural result from progress. When technology progresses or when effectiveness of (international) trade increases productivity increases and reduces production costs. Productivity increased 3-fold in many industries since 1970: Car manufacturers now assemble 100 cars/year/employee; Globalisation and resulting mass production reduced prices of electrical equipment to 1/3. Wheat production per acre tripled since the war and even American chickens now produce 4 times as much eggs than their un-improved African colleagues.

There is indeed not one single business sector whose productivity fell. Still core inflation is at 3% and the real cost of living actually increases maybe by 7-8% at this very moment. It is monetary policy targeting (core) inflation at 2-3% which prevents deflation and prevents the benefits of progress reaching the consumer. It is the FED's counterfeiting which confiscates the prosperity gains resulting from progress.

We have indeed many currencies competing worldwide. But the competition actually is about who debases the currency fastest. The current process of wild money printing is indeed very similar to competing devaluations during the 30ties. When the FED orchestrates the implosion of the dollar through negative real interest rates, Europeans cannot but do something similar if not their high Euro makes imports impossible. We all know where such a perverse mechanism of competing devaluations ended.

A gold standard does not mean to return to physical transaction of coins (although such would be possible and maybe in the end less costly than all the (hidden) costs bank and credit cards generate). A gold standard only means to give our currency the guarantee of a fixed amount of gold, and that the FED can no longer produce money out of thin air. A Gold standard avoids the present counterfeiting diluting the buying power of everybody else.

Learn more about desastruous effects of fiat money following excellent podcast :
What Has Government Done to Our Money? by Murray Rothbard

Martin Brock writes:


Suppose I operate a credit accounting service. I issue credit cards, and merchants agree to accept the cards. I don't lend money to card holders. Merchants extend credit, and I collect for them.

A merchant swipes a purchaser's card and provides a good. As the purchaser gradually pays the debt with interest to my service, I gradually pay the merchant with a bit less interest. The difference pays for my service.

Is my service possible under a gold standard?

Oliver Seidel writes:

Hello Russ,

your usual focus on the concept of "incentives" was not sufficiently pursued for my taste in this talk. My view is that private ownership entails private interest and that this would constitute the major criticism.

I was shocked about hearing VISA and fiat money in the same sentence.

What is your professional opinion on the viability of fiat money once it loses its anonymity (as the security and tax authorities of many current-day governments are working towards).

Thank you for giving the explanation of the aspects of a moderate inflation rate and its justification in psychology.

Please share with us a summary of the survey results.


Schepp writes:


Thank you for responding to my comment. I think that I agree with many of your points especially that productivity increases are good. However, I don't know that my point that money in most any form is a social contract was address. My point about gold is there is no reason the supply of gold should keep pace with growth of assets in the economy. Correlating a curreny unrelated total assets creates opportunity for inefficiency in the market by the distortion nominal value with true value created or added. The printing press mentality has certainly been tried by many governments, but the comepition places market restraint on that practice. As Mike Munger inidicated to Russ in his Boss and Bunny slipper podcast: Using a price system is not free. I would add the reasonable price for using a price system is the market price.

Martin Brock writes:

Oliver Seidel:

Refer to the credit accounting service I describe above. Do you have a problem with it?

Suppose Walmart permits you to purchase a $100 watch and pay for it in installments. You and Walmart use my service. You may pay for the watch in 20 monthly installments. Equivalently, you must pay at least five percent of your credit balance each month.

Suppose you pay for ten months and then stop paying. As I describe the service above, Walmart receives only half the price of the watch, ignoring interest payments. Is that a problem? Walmart actually agrees to extend the credit. A Walmart employee sees the person whose card they're swiping. I don't.

Suppose instead that I lend money to the purchasers. Then Walmart and Target are paid in full even if the purchaser makes only ten of the twenty required payments. Maybe the merchants like this idea better.

Suppose I may not lend money to purchasers; however, I may insure repayment. Merchants and/or purchasers pay me insurance premiums. In return for these premiums, I agree to pay the merchants when a purchaser fails to pay. Do you have a problem with this arrangement?

Martin Brock writes:


I didn't much like Cowen's explanation of the benefits of moderate inflation, but I suppose there's something to it. I prefer to think of inflation as a penalty for holding cash rather than using it to employ idle resources. Holding Treasury notes is even worse from this perspective, because the notes pay interest offsetting the inflation penalty. TIPS are incredibly awful in this sense.

From the perspective of labor, a free laborer continually employs himself. Even if he receives a wage, he employs himself in exchange for this compensation from his customer. Expecting the customer voluntarily to pay more under any circumstances is unreasonable, even if the laborer's real value to the customer increases. The laborer must demand his increased value.

When a laborer does not demand a higher wage in the face of inflation or an increase in his real value, he essentially holds the value of his own labor in a cash equivalent (his employment contract) and thus fails to reinvest it. The laborer needs to reinvest, either by negotiating a raise or by seeking a new customer.

Martin Brock writes:

Why don't public schools teach elementary economics and finance? Mine never did.

David Johnson writes:

I'm somewhat disappointed in this interview. I am a huge fan of Tyler Cowen, but that doesn't excuse Russ from asking him some pointed questions. As a free market leaning economist, I wanted to hear a cogent explanation of why government intervention in the money supply was necessary. Without that, his off hand dismissal of private money was insufficient for my tastes.

I'm naturally suspicious of macroeconomics. Too many variables have been wished away into the cornfield to provide the nice neat formulas of macro. Thus another line of discussion Russ could have engaged in, is why micro doesn't apply to money. Why must we forget everything we learned in micro just because we're dealing with money? There are lots of stuff I would like to hear two economists discuss regarding money and gold. I'm disappointed because I didn't get to hear any of them.

paul vreymans writes:

Martin Brock defends inflation as a Penalty for holding cash. This obviously reflects the very Keynesian idea that monetary contraction due to hoarding money reduces demand and is therefor the cause of recessions and depressions.

This tale about hoarding obviously is a fallacy because the effect on demand of hoarding money can only be nominal and cannot effect demand for goods and services in real terms. The reason is that You can indeed hoard money but never can hoard real buying power for following reasons:

1. Hoarding obviously can only concern coins and banknotes as all other savings find their way to active use by other market participants through the financial system. In the end increased investment or consumption on the lenders side of the financial system compensates for reduced demand on the saver’s side.

2. The fact is that coins and banknotes only represent a tiny fraction of the total money supply, presently no more than 1-5 % of the total money stock in many countries. As a consequence hoarding a small part of this tiny fraction cannot have a marginal effect on total demand.

3. Even this minor effect can only be nominal and not affect real demand because the temporally withdrawal of your coins and banknotes from circulation has the beneficial effect of increasing the real buying power of everybody else’s money by a tiny fraction. Hoarding coins and banknotes has in fact the reverse effect of counterfeiting, and even if hoarding of this hottest fraction of the total money supply would become widespread (which it unlikely as it is uneconomical to hoard “idling” money which could yield interest if deposited) the real buying power of non-hoarding individuals would consequently increase by so much that in the end the incentive to spend would become irresistible, and every tendency to a recession due to hoarding money would automatically have a self-healing effect.

Martin Brock writes:

I never anywhere assert such a thing.


No. "Demand" describes consumption and has nothing to do with the "penalty". Holding cash reflects the risk aversion of an investor. Means of production are always held, but that's beside the point. The problem with idle or underemployed resources is that they aren't held more productively. The solution to this problem in a capital market is an exchange of resources. When investors hold cash even in the face of many idle resources, they fear to invest for some reason. The last thing we want in this scenario is a riskless entitlement to consumption.


No. Hoarding cash has little to do with stuffing banknotes in a mattress. That's only a metaphor. The problem is precisely an unwillingness to extend credit. "Holding cash" is precisely the failure of the "financial system" to extend credit. The "financial system" is not some inhuman enactment of the state. This idea is precisely what I reject. The financial system is a lot of individuals with credit to extend.


Coins and banknotes have little to do with it. Money is credit. Coins and banknotes are only tokens of credit. I begin to address this issue above, but you don't respond. I do you the courtesy of replying to your points here. Do me the same courtesy. I ask you specific questions above. Please answer them.


Consumer demand is not the issue. Everything you say here is a non-sequitur. "Holding cash" doesn't describe money in a mattress. It describes holding Treasury notes and similar "securities" rather than accepting the risk of reorganizing real productive means, particularly idle resources.

Jonathan writes:

I humbly suggest Tyler Cowen re-reads the parable of the broken window as he seems unaware of the unseen costs of central banking and a wilful policy of currency debasement. To casually look at recent low macro volatility and summise that it was caused by central banks tinkering with interest rates is highly questionable, post hoc ergo propter hoc? ( but leaving aside the cause, he must realise a policy of inflation has unfair and unintended consequences? Those interested should read Mises on the myth of neutral money... .
A final thought concerns Tyler's concerns about deflation affecting the psychology of individuals. Undoubtedly I agree that 'getting from here to there (gold standard)' will be a difficult adjustment but a student of history will note that there has been a gold standard or similar for large chunks of human history where price/wage deflation was widespread over large spans (100s of years) of history. I respectfully suggest that TC is confusing 'good' deflation (that brought about by increased productivity for example) with 'bad' deflation (imploding credit excesses, not a bad thing in my opinion but clearly so for most indebted consumers).
Russ I love your shows and I am grateful you introduced an intelligent non-Austrian to your show but I was disappointed you didn't put up much of a fight.

paul Vreymans writes:

Dear Martin ,


In a transparent free market where the public knows the real business and investment risks, the savers’ choice between risk-free bonds and risky stocks is determined by the risk premium; say the net difference of long term yield of stocks over the long term government bond yield. For savers this risk premium over the risk-free rate is the price for accepting a greater volatility and greater uncertainty about future returns of venture investment. For the venture capitalist the risk premium is the incentive for hedging his investment with a loan.

I do not see why a monetary policy needs to fool people into riskier investment behaviour than they knowingly want to accept according to their risk profile or age group in the first place. In a free market, as soon as investment opportunities arise whose expected return is substantially higher than the risk-free rate, venture capitalists or fund managers will take advantage of the opportunity and invest in the promising venture. The risk premium therefore is the equilibrium price directing savings where they are most needed and where they are most profitable. Any intervention by the authorities in this market mechanism only disturbs the optimal allocation of resources.

Moreover it is highly questionable if inflation can fundamentally affect the risk premium in the long run and therefore influence saver’s investment behaviour. You can indeed only fool people with an unexpected inflation impulse for a very short time. Very soon people find out about the higher inflation and the risk-free long term interest rates will tend higher. Unless one engages on the path of an ever accelerating run away hyperinflation any stimulus the illusion of inflation could generate will soon be lost.

Money printing does indeed not provide any incentive to invest in “productive investment” as You suggest, but rather to invest in assets people expect to outperform the anticipated inflation. Money printing in practice each time creates a new asset bubble as it did in the internet bubble and the present home mortgage bubble and so many bubbles in the past. Each time these bubbles bust they cause poverty in hundreds of thousands of families.

See the The harsh reality behind foreclosures in this CNN program :

A much better tool to stimulate risk taking is improving business environment through deregulation and lower taxes.

Martin Brock writes:



I'm not sure it is. You're always free to hold gold or some other commodity if you want an inflation hedge. Maybe "risk incentive" isn't quite right. It's an incentive not to hold cash. If you're risk averse, you can still hold gold.

Again, "holding cash" refers primarily to cash equivalents like Treasury securities. When the Fed "cuts interest rates", it's buying Treasury securities, so it's encouraging investors to stop holding these securities by driving the yield down, even into negative real interest territory. Without a little inflation, this policy couldn't drive the yield below zero.


I don't know the long term yield of stocks in the future.


I don't wany any nominally risk-free rate ideally, i.e. I don't want any fiat debt secured by taxation, but that's a separate issue.


You mean leveraging his investment?


A small but consistent rate of inflation doesn't fool anyone into riskier investment, because real interest rates exceed this background inflation rate. The inflation only discourages holding cash. Why would you expect to gain anything by holding cash? I don't even want you gaining much by holding Treasury securities. I don't much want Treasury securities at all.


You're assuming that venture capitalists and fund managers are effective planners in this sense. They aren't. Capital markets are efficient. Venture capital is a gambling game. It's not about smart guys seeing the future. It's about risk takers placing their bets. Being smart helps a little on the margin. That's all.


A slightly inflationary monetary policy doesn't necessarily have "the authorities" doing anything. A slightly inflationary monetary policy tolerates a bit too much credit. If we aren't extending this credit to the state, I don't see the problem.


It at least influences the investor to hold a commodity or something rather than the money you don't want printed or Treasury securities. A stable rate of inflation does not fundamentally affect the risk premium, but when many resources are idle, tolerating freer extensions of credit is a reasonable policy, and this policy can be inflationary.


An unexpected inflation pulse is not what I defend, but if many resources are idle for some reason, I expect a pulse of credit to reemploy the resources in some speculative direction. This credit isn't necessarily inflationary. If it becomes very inflationary, we're edging toward malinvestment, i.e. an increasing proportion of us consume without producing comparable value. I expect growth of the state sector to have this effect. If it happens otherwise, we aren't creatively destroying the unprofitable organizations properly.


I don't want any risk-free long term interest rate, but I expect a positive real interest rate.


Inflation is not an illusion. An excess of fiat debt enabling investors to escape the inflation without really investing is a problem.


"Money printing" is extending credit or allowing people to buy things on installment, particularly the things people need to be productive. Repaying credit is "burning money". We don't talk about the burning as much, but both happen continuously. We tend to print a little more than we burn, i.e. we extend a bit more credit at interest rates a bit too low to compensate lenders, on the average, for defaults.

With the fiat debt mechanism, taxpayers subsidize lenders offsetting losses with fiat interest. Correpondingly easier credit then is a taxpayer financed system of researching the employment of idle resources; however, even without fiat debt, to keep resources employed on the bleeding edge of development, we necessarily tolerate unprofitable investments or credit that is never repaid. In principle, interest rates could be high enough to offset the losses, but no law of economics implies it.


These bubbles exist, and you don't have any magical solution to the problem. A gold standard is not this solution. Without the slightly inflationary monetary policy states pursue these days, we still have bubbles, and people still lose money in them. The internet bubble was an unsurprising result of investors seeking profit in an emerging business sector. Some people made a lot of money. Some people lost a lot. That's what I expect. I don't expect the gains precisely to offset the losses. I don't even expect the gains always to exceed the losses. Why would they?

Again, look at the credit extension service I discuss above. It can exist under a gold standard, right? And my insurance fund can become bankrupt, right? Maybe some merchants then declare bankruptcy too. Then courts clear the books, and we start over. A bit of inflation doesn't change this dynamic.

See the The harsh reality behind foreclosures in this CNN program :

Poorly regulated mortgage lending can have this effect with or without a small but consistent rate of inflation. Don't pay too much for a house, particularly if you're borrowing to purchase it. This advice is just as sound without a rising average price level.


"Deregulation" is a misnomer here. Private credit is not unregulated. It's regulated by private creditors. Lower taxes aren't necessarily helpful if the state replaces every dime of revenue with fiat borrowing. This substitution of fiat debt for taxation can increase inflationary pressures. The state keeps spending, and taxpayers try to consume more without really investing more.

Patrick writes:

I don't even want to listen to this interview. I'm afraid it will just anger me to hear some recommend a coercive monetary system.

Come on...On a moral basis, how could someone defend a system where citizens are coerced by the State to accept its money?

Russ: I hope you schooled Cowen for such nonsense.
ps. Mr. Cowen aren't you friends with Stefan Molyeux? He'd probably disown you for these views.

muirgeo writes:



- Woodrow Wilson

Dear Martin,

Sorry my previous comment was not clearer. The point I wanted to clarify is that inflation as a means to influence people’s saving or investment behaviour is neither wishful nor effective.

Every public interference in the market mechanism – be it through coercion or through the deception of inflation or through the fraud of counterfeiting - has the same effect of disturbing the market equilibrium and distorting the optimal allocation of resources. In the end every such intervention reduces the real level of wealth.

Even though markets are not perfect and individuals often lack the knowledge of all the information needed to figure out their well informed self interest as You objected, the big advantage of a free market is that mistakes by so many market participants tend to compensate, and the equilibrium reached in a free market comes as close to the optimal level as one can get.

One certainly cannot not improve the decision process in a free market by introducing an element of deception such as inflation or counterfeiting which deceives the perception of market participants all in the same direction. The equilibrium reached under such fraud will then be far away from the optimal level.

Lets look at an example: You can indeed fool people into saving -even at a moderate interest rate of 3%- when You deceive people that there is no inflation, as the incentive of 3% interest approximately equals the time preference most people have for immediate consumption over delayed consumption. However very soon savers will discover the buying power of their saved money lost -say 2%- the over the last year and realise and that they could have reached more consumer satisfaction by saving less, so -as one cannot forbid people to pursue their self interest- it will need at least 5% interest to convince people to save the year after.

You can indeed not fool people through inflation for a very long time. As Milton Friedman stated in an earlier podcast on this site, inflation if it is anticipated is getting You nowhere.
Well informed market participants soon learn to figure out their self interest in real terms and not nominal values. So if You want to continue to fool people in this direction, you need an ever accelerating inflation rate which soon would lead to hyperinflation.

What the FED has done over the last decade is systematically fooling rational expectations of people through the perfection of their art of deception. Information provided by the FED has indeed become increasingly misleading, both about money supply and inflation rates as well as through dispersion of very biased information about the business cycle. So has the FED stopped publishing M3 figures and now only provide misleading m2 figures while the “core inflation” rate gets further and further away form the real cost of living.

Such massive fraud makes it very difficult for most people to figure out their self interest and calculate the amount of money they should save and in which ventures to invest, which in the end leads to a lower level of wealth. Over the last decade the massive disinformation made people spend much more and buy much bigger houses than they could ever afford, to finally reach the point where people became over-indebted slaves of the finance sector. Infaltuion and negative real interest rates also pushed people into assets causing the one asset bubble after the other.

There is something fundamentally wrong about a financial system that deceives people from the one financial crisis into another, every time causing hundreds of thousands of bona fide victims. There is something fundamentally wrong about a financial system that periodically brings the world economy at the verge of collapse.

A financial system that through deception encourages over-indebtness and lays the cost of old age on future generations as it did in Europe and the US though PAYGO pension schemes and unfunded Medicare obligations is fundamentally wrong and immoral. Even so is a financial system that bails out the speculations of greedy Ferrari-driving bankers with tax payers money of hardworking citizens.

Our monetary system needs urgent reviewing with regard to its fundamental tasks. This not necessarily means the reintroduction of a gold standard, but a system where the money supply cannot exceed real growth. Some form of gold backed standard may indeed prove the sole system able to guarantee that and protect citizens against both over-expansive governments and greedy bankers.

Jakub J. Szczerbowski writes:

I never got to comment on your work as I am a lawyer in Europe and not an economist so your podcasts seem preety complete (great job by the way).

In this podcast you rise a question on how does the law look at the thing of private money. I want to add some foreign perspective on that. In most European civil law systems you have a rule that allows such contracts (so called rule of contractual freedom). Usage of private money, though, has certain drawbacks. E.g. in case of default of the debtor you couldn't sue for interests unless they were expressed in contract. Once you have a monetary contract you can To put that simple: private money is treated as mere things, like oil, horses or gold.

Sean writes:

The comment about the "price" of gold fluctuating is misleading. An ounce of gold in 1913 would buy a suit, shirt, and a nice pair of shoes and it will do the same thing in 2008. GOLD IS MONEY!

What is a "dollar". Per Black's law the definition is circular as it refers the reader to the "cent" and then defines the "cent" as one one-hundredth of a "dollar".

Per 31 USC 5112, it has a number meanings, a silver coin, a gold-colored base metal coin, and a paper note. But these "dollars" do not have equal trade rates between them in our current system as the real (silver) ones are now trading for about twenty of the paper or gold-colored coins. I find it tragically humorous that our law talks about "the sale price" of a "dollar" made of silver.

James N writes:

This is kind of trivial but I think the answer to the question "Why Gold?" has to do more with the physical properties of gold which have caused it to been historically used as a form of currency. Over time this caused a psychological association of gold with money, wealth, and status thus creating a de facto currency unassociated with a country/central bank.

Very generally, gold is fairly stable and nonreactive. 100 years from now, you'll most likely have all of the gold you had before in the same condition. It is easy to identify and difficult to counterfeit. It is very dense, so its value/space ratio is high. Further, it is malleable and easily divisible. Finally, it is inherently rare and valuable - there is demand to use it in jewelry because it is shiny and yellow (and recently important for scientific instruments), so even if no one will take it as currency you will likely be able to sell it for someone who has a physical use for gold. Those are just some I can name off the top of my head.

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