At the annual meeting of the American Economic Association in San Diego (January 4–6, 2013), Harvard professor of economics Benjamin Friedman said,
The standard models we teach … simply have no room in them for what most of the world’s central banks have done in response to the crisis.
Friedman also advises sweeping aside the importance of the role of monetary aggregates. On this he said,
If the model you are teaching has an “M” in it, it is a waste of students’ time. Delete it.
According to most economic experts, the Fed has re-written the central banking playbook, cutting interest rates to near zero and tripling its balance sheet by buying bonds. The federal funds rate target is currently at 0.25%. The Fed’s balance sheet jumped from $0.86 trillion in January 2007 to $2.9 trillion in January 2013.
Professors who say they agree with the Fed’s approach to the 2008–2009 economic crisis are nonetheless challenged to explain this new world of central banking to their students. They argue that the dramatic action by the central banks to counter a global financial crisis cannot be explained by traditional models of how monetary policy works.
So what seems to be the problem here?
According to traditional thinking, a lowering of interest rates stimulates the overall demand for goods and services, and this in turn, via the famous Keynesian multiplier, stimulates general economic activity. Furthermore, according to traditional thinking, massive monetary pumping should also lead to a higher rate of inflation.
Yet despite the massive monetary pumping, both economic activity and the rate of inflation remain subdued. After closing at 8.1% in June 2010, the yearly rate of growth of industrial production fell to 2.2% in December 2012. The yearly rate of growth of the consumer price index (CPI) fell to 1.7% in December 2012 from 3.9% in September 2009. Additionally, the unemployment rate stood at a lofty 7.8% in December 2012 with 12.2 million people out of work.
So why has the massive monetary pumping by the Fed, and the near zero federal funds rate, failed to strongly revive economic activity and exert visible upward pressure on the prices of goods and services?
Is the comment by Benjamin Friedman, that money is not relevant, now valid?
No. The fact that the massive Fed pumping has failed to produce the expected results—along the lines of mainstream models—does not mean that the money supply is no longer important to understanding what is going on.
The fact that economic activity is currently not responding to massive monetary pumping, as in the past, indicates that prolonged reckless monetary policies have severely damaged the economy’s ability to generate real wealth. So contrary to Friedman, we maintain that money matters very much. However, contrary to mainstream thinking, an increase in money supply does not grow, but rather destroys the economy.
The ongoing monetary pumping, coupled with an ongoing falsification of the interest rate structure, has caused a severe misallocation of scarce real capital. As a result of reckless monetary policies, a non-wealth-generating structure of production was created. Obviously, with the diminishing ability to generate real wealth, it is not possible to support, i.e., fund, strong economic activity.
Monetary pumping is always bad news for the economy because it diverts real funding from wealth generating activities to wealth consuming activities. It sets in motion an exchange of something for nothing.
As long as the economy’s ability to generate wealth is functioning, the reckless monetary policies of the central bank can be absorbed. Under such conditions, market watchers get the false impression that "loose" monetary policies are the key drivers of economic growth.
When wealth-generating activity, as a percentage of the total economic activity, drops below a certain point, reality takes over and general economic activity has to fall. This decline in wealth-generating activity undermines the ability to lend. Real funds for lending have also declined and lending "out of thin air" results. Following suit is the growth of the money supply and price inflation.
As a result of the weakened wealth generating process, formerly subsidized non-wealth-generating activities come under pressure. Since they don't produce enough to sustain their own viability, they are forced to lower their prices of goods and services to stave off bankruptcy. According to Mises,
As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap.
It is not clear whether we have already reached this stage in the US. But despite massive pumping by the Fed, economic activity remains subdued and this raises the likelihood that the US economy is not far from sinking into a black hole.