Fri Jan 21st, 2011 at 03:13:06 PM EST
Economists, economic commentators and moral philosophers (immoral philosophers in the case of the Austrians) from both the left-wing and the right-wing critique of orthodox economic tradition have seemingly joined forces in attacking "easy money" and the illusion that it is possible to moderate the business cycle through interest rate policy. But go beyond the sloganeering, and you will find that there are substantial differences between the different critiques. In the effort to understand these differences, I find it helpful to distinguish between three sorts of "easy money:"
- Money can be "easy" in the sense that one can borrow on little or no margin.
- Money can be "easy" in the sense that lenders are less than duly diligent in reassuring themselves that the collateral or business plan against which the money is borrowed is sound and worth the full amount of the loan.
- Money can be "easy" in the sense that one can borrow at a low interest rate.
Now, in the orthodox tradition, these three come to the same thing. Lenders, in the orthodox tradition, optimise the present value of their portfolio, given their individual desired risk profile. Whether risk in this picture comes from absence of sound collateral or absence of sound margins is a matter of the most supreme indifference. When the orthodox tradition speaks of "easy money" or "hawkish monetary policy" (not to be confused with "hard currency," which is something else entirely), they therefore speak exclusively of the interest rate floor set by the central bank.
Most of the right-wing critique of "easy money" shares the orthodox fixation on interest rates as the be-all-end-all of monetary policy, along with a heaping helping of misunderstandings about what money is and how central banks work.
In the Austrian fantasies (I shan't dignify them with the terms "model" or "theory," because they bear no discernable relationship to empirical reality), deposits create loans. Which means that the central bank, by providing the banking system with reserves, depresses the interest rate below what it would naturally be if the money markets were free to set the interest rate on their own. The Austrian critique of "easy money" therefore focuses exclusively on the central bank's purported lowering of the interest rate, and neglects or deliberately ignores margins and lending standards. After all,no bank wants to lend against garbage collateral. Right? Most of the rest of the right-wing critique of "easy money" follows the same broad outline, but with a lot less coherence and rather more conspiracy theories.
A full critique of the Austrian delusion is beyond the scope of this diary (and, frankly, not worth the time it takes to read it, nevermind the time it takes to write it). But the high (or low, if you will) points are as follows: In the real world, loans create deposits, not the other way around. This being the case, the role of the central bank is not to suppress the interest rate - rather, the central bank's role is to support the interest rate. If the central bank went away tomorrow, it would be in every way equivalent to the central bank setting the policy rate to zero. At least in terms of interest rates, and neglecting the regulatory roles of the central bank (which seems a reasonably safe assumption at the moment, since the central bankers appear to be neglecting the regulatory roles of central banks as well).
One might be forgiven for assuming, based on the above discussion, that I will now make the case for a left-wing critique that completely separates the three sorts of "easy money." One would, however, be wrong.
It is obviously silly to pretend that the three kinds of "easy money" outlined at the beginning of this diary have no overlap. To some extent the borrower can pledge superior collateral in return for a lower margin, and to some extent the borrower can post shady collateral and low margins if he is prepared to accept a higher interest rate.
But collateral, margin and interest rates are not perfect substitutes for one another. In particular, their behaviour during bubbles differs rather markedly. Reasonable margin requirements are by far the easiest way to dampen bubbles, because they force the speculator to put up a reasonable amount of high-powered money up front. Stringent standards for acceptable collateral could also undercut bubble-inflated pricing, but are harder to enforce. Interest rate intervention, on the other hand, has almost no power in and of itself to undercut a speculative bubble. Speculative asset price inflation will almost always outstrip legitimate gains from legitimate businesses, so if you squeeze the gambler hard enough to hurt him, you're at the same time squeezing the honest businessman hard enough to kill his business.
In summary, the main difference between the left-wing and the right-wing critique of easy money boils down to the right wing believing, or professing belief, that financial institutions are capable of pricing systemic risk into the price the borrower pays for less stringent collateral and margin requirements. The right-wing critique therefore argues that simply jacking up interest rates will suffice, because the most risky loans will be priced out first.
The left-wing critique, on the other hand, sees no evidence that this is actually the case in the real world, and therefore recommends dealing directly with the fundamental problem - inadequate collateral and inadequate margin. In this picture, the interest rate is relatively unimportant as a tool to manage bubbles, and should be kept low in order to encourage productive investment.