Sunday, February 8, 2009

Bad Time Murphy

Robert P. Murphy is out with a column at, which provides a unique prescription for a Bad Time economy: raise interest rates. He manages to provide this prescription without once mentioning real interest rates, or the money supply.

This folks is a feat. It is as though The Who's deaf, dumb and blind Pinball Wizard is for real and is playing pinball at an NYU rec room, while on a unicycle, chugging Red Bull.

Murph's basis for his prescription for high rates is a shred of empirical data he discovered about the 1920-21 downturn. He writes:

...the highest the New York Fed ever charged banks was 7 percent. And the only time it did that was smack dab in the middle of the 1920–1921 depression.
Now, the initial reaction to this data might be, interest rates higher and the economy is in recession, yeah, so what else is new? One would think that with rates higher, the money supply growth is being choked off, thus causing the downturn.

Note: Murph does not provide any money supply numbers to check this fact. I checked, money supply did indeed shrink, by 9%!

Now the 1920-21 downturn was a quick one. As Murph points out:
Although you've probably never heard of it, this earlier depression was quite severe, with unemployment averaging 11.7 percent in 1921. Fortunately, it was over fairly quickly; unemployment was down to 6.7 percent in 1922, and then an incredibly low 2.4 percent by 1923.
So with such a dramatic change in the economy, you would think that the Fed cut rates and that money supply climbed.

Yes, indeed, that is exactly what happened. The peak in the New York Fed discount rate was Murphy's aforesaid 7%, which ended after April of 1921. By December of 1921 the New York discount rate was down to 4 1/2%. Now, the amount of money growth a rate cut causes is dependent on the real interest rate. The real rate is the rate that would occur in the markets if the Fed was not manipulating rates. If the real rate in 1921 was 5 1/2%, then a Fed discount rate of 7% is not going to produce any new money. Who is going to borrow from the Fed if the real rate is 5 1/2% and the Fed wants to get 7%? On the other hand, a rate of 4 1/2% when the real rate is 5 1/2% means a bank borrowing from the Fed is getting real cheap money. Now there is no magic place you can look for the real rate when the Fed is manipulating rates. The only way you can tell if the Fed rate is above or below the real rate is to see if the banks are borrowing from the Fed and money supply is going up or down.

Clearly, in 1921 at 7% the Fed rate was above the real rate. As the Fed cut rates down to 4 1/2% the money supply started to climb, indicating the real rate was above the 4 1/2% rate.

Thus, not surprisingly, as Milton Friedman and Anna Schwartz point out in their classic, A Monetary History of the United States, the money supply grew by 10.3% from July 1921 to May 1923. That's what fueled the boom in the economy after the 1920-21 downturn.

Now, Murphy on the other hand gets excited about the 7% rate in the middle of the downturn and tells us that's what caused the boom after the downturn. He writes:

There is a perfectly good theoretical explanation for why the record-high rates in the early 1920s were the right policy, while the record-low rates in the early 1930s were the wrong policy.

He then quotes Lionel Robbins:

Now in the pre-war business depression a very clear policy had been developed to deal with this situation. The maxim adopted by central banks for dealing with financial crises was to discount freely on good security, but to keep the rate of discount high. Similarly in dealing with the wider dislocations of commodity prices and production no attempt was made to bring about artificially easy conditions. The results of this were simple. Firms whose position was fundamentally sound obtained what relief was necessary. Having confidence in the future, they were prepared to foot the bill. But the firms whose position was fundamentally unsound realised that the game was up and went into liquidation. After a short period of distress the stage was once more set for business recovery.
The problem with this quote is that again, there is no data to tell us what is going on at the time. Is the money supply contracting or expanding? Do the central bank rates appear to be above or below the real rate? Yet, Murphy some how concludes from this Robbins paragraph that there is "theory" behind his proposal to raise rates till kingdom come.

In fact, I suspect that what Robbins is really saying is that the Central Banks got out of the money manipulation business completely. They didn't shrink or expand the money supply.That's the best way to read what Robbins writes when he says, "... no attempt was made to bring about artificially easy conditions."

Not Murphy's tough love of 7% rates, just rates that are not artificially easy. That to me means a rate that is equal to the real rate.

But, instead of calling for a return to real rates, Murphy is calling for "high" rates. He writes, the high rates were, "painful, but they had cleaned the rot out of the structure of production very thoroughly."

In short, Murphy in this paper reminds me of those economic micro-managers who think they know what is best for the economy as evidenced by the details of their micro-management programs, when there is a free market solution that can take care of such issues in a better and faster fashion. This high interest rate prescription of Murphy's could be too low, too high or just right depending upon what he defines as "high" and what the real rate is.

Just what rate does Murphy want for the current economy? The absurdity of this question, (What is he going to do wet his finger and put it up to the wind to tell us?) nearly by itself makes it impossible to understand how such a policy could be implemented.

The real solution is much simpler than this twirling, nosedive into uncharted waters. The Federal Reserve should just stop manipulating the money supply, let interest rates go where they may--that will be the real rate, and it will end the business cycle forever.


  1. The more you post on this stuff, the more it is apparent that you believe printing presses cause prosperity.

    It was a growing money supply that electrified rural America and allowed Henry Ford to crank out hundreds of thousands (maybe millions, need to check) of first-time cars for people? Cool.

    Say, the economy kinda sucked in the last quarter of 2008, didn't it? So the money supply shrank, right?

  2. @ Bob Murphy

    You write:The more you post on this stuff, the more it is apparent that you believe printing presses cause prosperity.

    In my last paragraph,I write: The real solution is much simpler than this twirling, nosedive into uncharted waters. The Federal Reserve should just stop manipulating the money supply..

  3. I thought the Austrian School theory of business cycles is that they are caused by fractional reserve banking, not interest rate manipulation.

  4. @ No Axe

    You have a very good point. Interest rate changes occur as a result of fractional reserve banking, but the key is how much money is entering or leaving the system.

    Just knowing whether the Fed hiked or cut a rate, without knowing where the "real" rate is, is nothing but clueless banter.

    Murph is thread on thin ice on this one, as a matter of fact I believe he has fallen through the ice.

  5. Mr. Wenzel:

    Indeed, your closing paragraph did suggest that the Federal Reserve should stop manipulating the money supply.

    However, somewhat earlier you said,

    "Thus, not surprisingly,. . . the money supply grew by 10.3% from July 1921 to May 1923. That's what fueled the boom in the economy after the 1920-21 downturn."

    While you may not have come out and said that an increased money supply creates prosperity, this sort of sounds like what Murph said,

    "that you believe printing presses cause prosperity."

    Perhaps this is to what Murph was referring? I'm just trying to reconcile his comment with your rebuttal.

  6. @ Aristos

    Thanks for your comment. This is important stuff.

    Money supply growth often does fuel booms, however distorted and dangerous they may be--dangerous by leading to, for example, inflation.

    I am certainly not advocating such a money fueled boom, but they are a fact of life. That's how the boom of the early 1920's occurred. And that is the kind of boom we are headed right into, now.

    As I stated in my closing paragraph, the Fed should stay out of the money supply manipulating business.

    Murph is being a bit disingenuous when he accuses me of believing that money printing brings "prosperity". He knows I don't believe that. Money supply, however, can cause booms that are recorded as such by government data--but are structurally unsound booms.

    Murph is just trying to keep eyes away from his impossible to defend call for high a interest rate policy to fuel a boom--when he doesn't talk about how high--and doesn't even mention any relation to "real" rates and its impact.

    But, hey, Murph's a good guy and he had a deadline to make.I'm sure if he was running the Fed he would not actually follow through with a high interest rate policy that didn't also consider what impact it had on money supply growth and also its relation to "real" rates

  7. Robert, is this an end to the mutual admiration society, or is this just tough love?

  8. Robert Wenzel, you are right that the real interest rate is best. While Murphy doesn't explicitly mention the real rate, he does allude to it:

    "It's actually easier to see if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. . . they should raise their prices. "

    My understanding of his theoretical argument is that the real interest rate (i.e. price of money) will go up in a bust period, and thus the central bank should raise it's rate to be closer to the real rate.
    I'm fairly certain that Murphy would see a free (non-monopoly) interest rate as preferable to a central bank enforced rate, I think the primary point of his argument is just that interest rates should go up in a bust period. He should have made it clear that allowing the rate to freely rise is preferable to the central bank raising rates if he does in fact believe so.