Monday, March 2, 2009

Robert Murphy: Money Policy and Interest Rate Policy Are Different Things

Well, so much for my dispute with Robert Murphy over the difference between interest rate policy and money supply policy. In a powerful article at, he makes clear that there are important differences between interest rate policy and the money supply policy.

Among Murphy's gems in this article are these:

[During the economy's current crisis period] the alarm [that] needed to [be] flood through the world [is]: "Save more! Save more! This is an emergency! The entire structure of capital is at risk if we don't plug these holes soon!" the single most crucial time in world history for interest rates to rise sharply, they were instead pushed down to zero. Just when extra saving is needed most critically, instead the governments of the world have caused lending itself to become almost pointless.


Interest rates are prices, and as such they convey real information about scarcity in the world. People talk of financial affairs spreading into the "real economy," as if the allocation of capital is some minor detail. On the contrary, the capital markets — guided by interest rates — are the single most important "governor" of the "real" market economy over time.

By flooding the credit markets with money created out of thin air, the central banks of the world are interfering with humans' attempts to communicate with each other after the housing bubble popped. It would be as if the governments used military aircraft to jam the radios of rescue workers in a region hit by an earthquake.

The politicians and bureaucrats talk as if the members of the private sector are aloof during the crisis. On the contrary, people the world over are concentrating on their finances more than ever. But the governments of the world keep drowning out the signals people are trying to send to each other.

One disagreement I have with Murphy in his article is that he doesn't seem to be clear about demand for money in the sense of money already in existence that is simply being borrowed versus a demand for newly created money. My belief is that there never is a need for newly created money. If productivity increases, prices would simply drop in a fixed money supply world. Although Murphy does talk about gold miners digging up new money, i.e. gold, I think he is leaving too big an opening for Chicago school types and other stable price level types to go in and call for manipulation of the money supply.

Especially when he concludes (my emphasis):

Money and interest are distinct things. There are times when the "right" market response is an increase in the supply of money and an increase in interest rates.
I don't think there ever is the necessity for an increase in money supply. I'd much rather see us, say, on a fixed dollar supply standard than a gold standard. I know that the argument has always been that a gold standard will prevent politicians and bureaucrats from increasing the money supply, but look how well that has worked during our prior gold standard years, i.e. we lost the gold standard. In truth, the only way we are ever going to get a sound money standard is when the public at large understands the importance of sound money, and at such time a fixed money standard will work as well as, probably better than, a gold standard.

I hasten to add that during a period when the public is as clueless as it currently is about the importance of sound money, gold is the natural vaccination that will protect against the idiocy of the general public and the ultimate inflation that will occur. In other words, right now, you better own a lot of gold.

Another problem point about the article is simply with a direction Murphy doesn't take the article, and it is more of a technical point about Fed operations, but nevertheless an important technical point. The Fed lowering interest rates does not necessarily mean the Fed is increasing the money supply. It depends on the "real interest rate", where I define the "real interest rate" as what the market rate would be without Federal Reserve money manipulations. This summer, for example, the Fed lowered interest rates, but I believe the "real rate" was even lower than the rate they cut too. Thus, while they might have thought they were easing money supply, they, in fact, were maintaining a near stable money supply and not easing money supply at all.

This is a very important technical point to understand, not only are interest rates and the money supply different things, but cutting rates does not mean necessarily mean the Fed is easing money growth. Likewise, increasing rates does not mean the Fed is tightening money supply, if the "real" rate remains above the point where the Fed has raised rates too.

That said, Murphy's article is a must read in understanding many of the dynamics of money and interest rates.

1 comment:

  1. Incidentally, I have never disagreed with your basic point about (what you call) the "real interest rate" and money. Did you ever read this article?

    I was just arguing with you because you thought that insight (which is a good one) somehow invalidated my other article.