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Source link: http://archive.mises.org/8909/guilty-as-charged/

Guilty as Charged

November 7, 2008 by

David Henderson and Jeff Hummel have managed to ruffle quite a few Austrian feathers with their recent Cato briefing paper, and no wonder: that paper claims not only that Alan Greenspan’s Fed was innocent of any role in encouraging the housing boom but that Greenspan had actually managed to do something Austrian monetary economists have long claimed to be impossible, namely, solve the monetary-central-planning problem. Greenspan, by their assessment, managed to mimic the kind of money-demand accommodating money supply growth that would occur under free banking, thereby achieving (according to their paper’s executive summary) “a striking dampening of the business cycle.” FULL ARTICLE


magnus November 7, 2008 at 8:00 am

If central banking’s goal is to be a perfect mimic of free banking, then what do we need central banking for? Why not just have free banking then?

I submit that it is a self-evident truth that central banking exists for the purpose of operating in a way that is, in some significant way(s), UNLIKE free banking. That un-free banking is its raison d’etre.

StatusQuoJoe November 7, 2008 at 9:11 am

As is often the case I am plagued by a desire to shoot my mouth off when I don’t really understand all of the issues. In that light and in fervor of my disease I will say that statistics is a game treasured by scientists, engineers, politicians and economists alike (among others). Hindsight is 20/20 and statistics are the rose colored lenses that afford a selective perspective.

Fiat money thrives on selective perspectives and a true commodity based money supply would go much further in serving the common man’s interest since he understands it much better and after all it is important to keep the common man’s confidence together when dealing in a collective economy. Lose the common man’s faith in the system and you lose the system itself. I for one common man have lost faith in the fiat money system.

Ted Berthelote November 7, 2008 at 9:30 am

Cato has been purchased by Leviathan, which does indeed explain much here.

greg November 7, 2008 at 9:42 am

Your sub prime – fed funds rate analysis is slightly off the mark. Home sales started to trail off in 2004 as builders were seeing specs sitting longer. Values were not rising as fast as in the past. Builders and real estate investors needing to feed their operations needed to continue to add more inventory to carry the cost of completed unsold homes. This means they have to expand their borrowing into sub prime which led to the over leverage. And with banks not being forward looking, they were willing to lend on their past record.
This was really easy to see and one of the key reason I built my last spec home in 2004. And I see the market starting to make a turn and that is why I have started planning my next spec before the end of the year.
You can try to put the blame on the Fed for the housing market problems, but the reality is it is more about supply, demand, cost and speculation. And the main fact that real estate is a not a good short term investment as the transaction cost to buy and sell is too high.

George Selgin November 7, 2008 at 10:14 am


“Supply, demand, cost, and speculation” have been with us forever. The question is, What changed after 2000? Well, the supply of mortgage credit changed, for one thing, and it did so, I believe, in large part because of the Fed’s easy-money policies. Of course many other factors were at play, shunting credit were it has no business going under any circumstances. But the Fed deserves blame for providing much of that misallocated credit.

Tim Kern November 7, 2008 at 10:16 am

C’mon, people. Let’s just admit that the housing bubble grew because we all believed we could unload our houses at a profit whenever we wanted to. We had seen that trend for over a dozen years, and lenders were still interested in supplying us with money.

The only ones who are lamenting the bursting of the bubble were those who were holding properties when it popped.

PS. Does anyone want a house in Florida? I have two there…

George Selgin November 7, 2008 at 10:20 am

Folks, if an “explanation” doesn’t explain the timing of the boom, it doesn’t explain the boom!

JIMB November 7, 2008 at 11:29 am

The fact that the Fed will backstop the system means the theft occurs prior to the actions of the central bank to offset the results … so the thievery can be pumped into a monumentally large scale by deferring the costs to others. That is ‘looseness’ (in morals for sure) no matter what the money supply figures do and it will alter behavior substantially to the negative, destroying wealth.

Stephan Kinsella November 7, 2008 at 1:07 pm

Boudreaux agrees with Selgin, as do Horwitz and Karlsson, while Jane Shaw seems noncommittal, and Bill Woolsey mounts a defense of the Hummel/Henderson thesis.

Eric D. Dixon November 7, 2008 at 1:39 pm

From the article:
“After all, if the choice between free banking and central banking is merely a matter of ‘preference,’ rather than a choice between arrangements with inherently distinct capacities for either limiting or exacerbating business cycles, then there are strong prima facie grounds for dismissing radical and (recently) unproven alternatives in favor of the status quo.”

Selgin makes too much of the word choice here, and probably creates a false dichotomy. I suspect that Henderson and Hummel would confirm that their “preference” for free banking arises from the fact that they recognize it has an inherently better capacity for limiting business cycles.

Jonathan Atkins November 7, 2008 at 3:12 pm

Dr. Selgin: Thank you for one of the most rational, objective, and intelligent pieces I’ve read on this site in a long time. Your scholarship should be an example to all, especially graduate students such as myself on how not only to write, but to think. It would be a privilege to be your student.

George Selgin November 7, 2008 at 4:28 pm

To Jonathan,

Thanks for the compliment. I’d be happy to have you apply to our program whenever you’re ready–not UGA, mind you: I’m at WVU now!

Beta Hater November 7, 2008 at 4:42 pm


“You can try to put the blame on the Fed for the housing market problems, but the reality is it is more about supply, demand, cost and speculation.”

Are you arguing that the Fed does not influence “supply, demand, cost and speculation”? I would disagree and argue that the Fed has significant influence over such factors.

Eric November 7, 2008 at 6:00 pm

If the subprime expansion was NOT fueled by excess credit then it would have had to come from the existing credit available.

But if it came from existing credit, then simple math would tell you that somewhere in the economy, the existing credit had to be REDUCED in order for it to EXPAND into the subprime market. We either have a zero sum game or we don’t. Either the money supply is fixed or it isn’t.

Now if credit was being moved from one part of the economy into another, why didn’t we hear complaining about a lack of credit somewhere. This silence would seem to me to be evidence that it was indeed new credit, and tons of it, that fueled the subprime markets.

Any comments here would be appreciated, as I can’t see anything wrong with the above logic.

greg November 7, 2008 at 7:02 pm

Lets look at what sets mortgage rates. It is set by Libor or by the T-bill auctions. The only interest rate that is directly influenced by the Fed Funds rate is the prime interest rate. And yes, we have had speculation with us for ever, but we have never and I must repeat this never had such an explosion in investment funds, indexes, future and option contracts tied to indexes than we have had in the last 10 years. A person doesn’t even need a option account to invest in these which opens the market wide for participation. It happen to real estate, oil, wheat, gold, and every thing people can dream up to put money down on basically a bet.
Now, you may say these investments would not be possible without an increase in money supply, but I would think not.
You must understand the housing market to get a real handle on the business. It takes 6 months to plan, build and have a house ready for the market. In a world of JIT inventory control, the housing market just doesn’t work. It was influenced by over demand and could not act fast enough when the market turned. Builders caught in the downturn needed to continue the starts to pay for the inventory sitting. Then they reach the end and the foreclosures start.

Dan November 7, 2008 at 10:05 pm

I think the problem can be simplified even further: The Fed creates the money and destroys it according to their whims (government policy such as “affordable housing” for example). This money creation and destruction is manipulative and deceitful. They bear the sole responsibility for initiating the manipulation or deceit (after all they have the monopoly on money!). They know full well that most people aren’t educated enough to understand money banking.

Dan November 7, 2008 at 10:09 pm

Sorry. That should’ve been money & banking at the very end.

Lucas M. Engelhardt November 8, 2008 at 12:17 am

I’d probably make the following argument:

(1) The Fed was expanding credit around ’02-’03 or so. This is clear in the data. From March of ’01 to March of ’02, the total amount of loans by commercial banks was almost unchanged. Credit was not expanding. Then, in March of ’02, credit started expanding again, and continued to do so at about a 10% annual rate. Looks like a credit expansion to me. At the same time, the monetary base was increasing very quickly (for example, from March of ’02 to March of ’03, the monetary base increased by 7%). So, new money was being created, and was being channeled through credit markets. So, where would it end up?

(2) Deliquency rates on real estate were very low during 2002, especially compared to other types of loans. Commercial and Industrial loans saw delinquency rates double from 1999 to 2002. Meanwhile, real estate loans were pretty reliable, and from 2002 to 2006, they had exceptionally low delinquency rates, making these loans look very, very good. So, easy credit flowed toward real estate loans… like mortgages. (Feel free to add in stories about mortgage backed securities, the Community Reinvestment Act, etc., if you want.)

(3) Increased availability of mortgages drove people to buy homes, which pushed up prices. (Biggest price increases, as measured by the Case-Shiller 20 where from July 2003 to July 2004, after the increase in credit… indicating that the supply of credit started the housing boom, not that the housing boom made credit more available.)

(4) Bubble dynamics started kicking in. People expected prices to continue increasing at absurd, unsustainable rates, and expected interest rates to stay low. Based on these false expectations, people joined the parade.

(5) Naturally, this could not last. Even if the credit expansion continued (and it did until early 2008), real estate prices would have to stabilize and/or fall. They started to stabilize in late 2005, and that “pricked the bubble”. In August of 2006, home prices started falling, killing any “speculative demand” for housing, which made prices fall faster. This flips some homes upside down (mortgage-wise) and foreclosures follow.

So, does “speculation” play a role? Sure. But, the data seems to indicate that this bubble may have been “fueled” by unreasonable, yet temporarily “self-fulfilling” expectations, but that such expectations did not “ignite” the bubble. People needed a reason to believe in real estate prices going up. The reason was there. Real estate prices had been going up. Why? Because credit to buy real estate was available in unusually large quantities at unusually low interest rates.

I think that it’s quite difficult to try to explain why the bubble dynamics would start if there was nothing starting them. Poor Fed policy gives us the spark needed to explain the fire, even if the fire might be “self-sustaining” for some temporary period of time. If we want to claim that it’s not the Fed’s fault, we have to come up with some other explanation of the housing boom. And, it has to explain: increasing housing prices, increasing home sales, increasing real estate loan volumes, and low mortgage rates, all without Fed policy having anything to do with it. I haven’t seen an explanation that manages to do that. Meanwhile, the explanation laid out here seems to work pretty well, and make sense.

DS November 8, 2008 at 2:24 pm

Is nobody going to mention Mal-Investment?

That’s the real issue here. Comparing relative amounts of fiat money creation between periods assumes that the conditions in each period are the same. The M-I effects of a given amount of fiat money creation depend on which industry is the path of least resistence for the liquidity to follow.

But Mal-Investment can have different effects in different time periods. Anecdotally, I look at the proliferation of subsequent Mal-Investments as prima facie evidence of excess fiat money creation.

David Hillary November 8, 2008 at 8:25 pm

I’m not sure why Selgin buys into monetarist/quantity theory at all, since he is a free banker.

Under free banking and a metallic standard, the relative price of a representative basket of consumer goods, in terms of monetary metal, is anchored by the supply and demand functions of monetary metal, where the price is measured in terms of that basket of goods. Should the actual price of monetary metal rise above the price where supply and demand are equal, there will be a surplus in the monetary metal market, i.e. the stock of monetary metal, in other words the metallic monetary base, will be increasing over time. In the same way if the monetary metal price is lower, there will be a deficit, and the metallic monetary base will be decreasing over time.

The stock of monetary metal is a form of capital subject to diminishing marginal returns, and according to White’s bank profit maximisation model, the marginal revenue product of monetary metal is the nominal interest rate. Thus there is a negative relationship between the interest rate and the stock of the monetary metal.

Selgin should go back to the drawing board and start afresh rather than adopting monetarist or similar macro theories.

George Selgin November 8, 2008 at 9:08 pm

Even allowing that Mr. Hillary understood the theory of a metal-based free banking system (which he evidently doesn’t–consider for starters his bizarre claim that interest rates depend inversely on the stock of monetary metal), why does he suppose it has any relevance for assessing the Fed’s recent conduct? Does he imagine that the Fed is still disciplined by a gold standard?

David Hillary November 8, 2008 at 11:36 pm

George Selgin,

Thanks for your response.

You stated my claim that there is a negative relationship between the nominal interest rate and the stock of metallic money is bizarre.

I gave several bases for this claim, and you have addressed not one of them. It appears you have dismissed it out of hand.

I invite you to respond to the following elements of the claim with true or false:
1. The stock of metallic money is part of the physical capital stock of the economy.
2. Holding the stock of metallic money has an opportunity cost to the holder, being the rate of return that could be earned by holding alternative assets such as interest bearing securities.
3. Holding the stock of metallic money also has a marginal rate of return, without which there would be no demand to hold metallic money. Demand exists to hold metallic money to the extent that it can generate marginal returns no less than the marginal costs of holding it.
4. The marginal rate of return on metallic money, as a form of capital, diminishes as the stock of metallic money in an agent’s portfolio increases (cf. White’s bank profit maximisation model). This also applies to the market as a whole, i.e. the aggregate of all agents’ portfolios. The law of diminishing marginal returns applies to metallic money as a form of capital. The demand curve for holdings of metallic money is downward sloping. Agent portfolios typically find that, after some point, further holdings of metallic reserves is not the best investment, and that typically other assets are also held.
5. No technology exists in the financial sector to change the stock of metallic money in a short time. Issuing and redeeming securities, including demand deposits and banknotes, does not change the stock of metallic money whatsoever. In the same way the mining and manufacturing sector cannot increase or decrease the stock of metallic money rapidly, and unless the purchasing power of the monetary metal changed rapidly, would have no incentive to either produce or consume more of it (assume that the stock of uncoined bullion was negligible, i.e. normally the monetary metal was coined unless required for immediate industrial use. Alternatively uncoined bullion can be considered part of the monetary base, subject to manufacturing capacity to quickly turn it into coin). The purchasing power of the monetary metal is inflexible in the short term, and can only creep up and down over time through inflation or deflation. Thus, for all intents and purposes, society’s stock of metallic money is fixed in the short run.
6. The market interest rate on money can then be modeled as the intersection of a downward sloping demand curve and a vertical supply curve, at any point in time. The interest rate rations the existing stock of metallic money to the agents who are most willing to forego interest to hold it. Should the demand to hold metallic money increase, the stock of metallic money does not increase, only the price (interest rate) does. In the same way should the demand to hold metallic money decrease, the stock of it will not decrease, only its price (interest rate). Thus the stock of metallic money is always willingly held, at some price, and always available to hold, at some price. Changes to the metallic money stock can only emerge over time through surplus or deficits in the market for the monetary metal, and how this occurs is what I am inviting you to explore.

The relevance to the Fed conduct? I don’t think that is the question for me, I think it is the question for you: why is George Selgin, a free banker (not sure if you count yourself as an advocate of a metallic monetary standard) engaged in this critique of the Fed, using so many of the same models, theories and assumptions re macroeconomics? I think it would be more fruitful for you to leave orthodox macro theory and re-examine free banking on a metallic standard and work from there to develop a new macro-theory. (I also regard existing macro-theory flawed,hence my interest in starting again.)

newson November 9, 2008 at 6:56 am

david hillary says:
“In the same way if the monetary metal price is lower, there will be a deficit, and the metallic monetary base will be decreasing over time.”

how could this possibly occur? under what circumstances would the metallic monetary base shrink in a free market? how can there ever be a deficit/shortage of money in a free market? it’s like saying i can’t measure an elephant because i’ll run out of millimetres.

David Hillary November 9, 2008 at 12:48 pm


A deficit just means that the rate of monetary metal consumption, e.g. industrial and jewelry use, is greater than the rate of mining, thus the stock of monetary metal, in the form of money or bullion, reduces. This releases or divests capital from the form of money or bullion, in the same way that a surplus in the market uses up or invests capital in building up the stock. This is the same as any other inventory in the economy, e.g. materials, work in progress or finished goods.

David Hillary November 9, 2008 at 12:53 pm


For clarification: a deficit in the market for the monetary metal does NOT mean that the stock of the monetary metal reaches zero or goes below zero, it just means it is going down for a time. There are reasons why the stock of the monetary metal will not reach zero: the interest rate will rise, causing deflation, which causes the price of the monetary metal to rise, which ends the deficit and begins a surplus in the market for the monetary metal.

Bruce Koerber November 9, 2008 at 8:50 pm

When someone is ‘charged’ it is technically an offense. When someone is ‘guilty as charged’ it is proven that the person took action that caused the offense.

Greenspan (others have also committed these ‘crimes’) is especially culpable since it is known that at an earlier point in his life he actually knew better. Greenspan is guilty as charged.

The offense is what? Since it is an offense it is impossible to separate it from the science of ethics. Ultimately it is impossible for the finite mind of a human (even when the finite mind teams up with a fast tool designed by a finite mind) or the finite minds of teams of humans to comprehend and encompass the infinite! The market with its subjective nature and its link with uncertainty is an example of our encounter with infinity. It is unethical to lie to oneself and to others about the unknowable intricate details of the market.

The interest rate is one of those intricate details. It is unethical for Greenspan and those like Greenspan (empirical, ego-driven interventionists) to deliberately corrupt a signal that natually dispenses justice.

Greenspan is guilty as charged.

David Hillary March 21, 2010 at 3:07 am

well perhaps it is not a bizarre claim after all:
‘The adjustment process in the financial market under a gold standard will work through changes in interest rates. When the US money supply rises after the gold discovery, average interest rates will begin to fall. Lower US interest rates will make British assets temporarily more attractive and US investors will seek to move investments to the UK. The adjustment under a gold standard is the same as with goods. Investors trade dollars for gold in the US and move that gold to the UK where it is exchanged for pounds and used to purchase UK assets. Thus, the US money supply will begin to fall causing an increase in US interest rates, while the UK money supply rises leading to a decrease in UK interest rates. The interest rates will move together until interest rate parity again holds. ‘ http://internationalecon.com/Finance/Fch80/F80-2.php

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