06 Feb 2009

Banks Should Raise Prices in a Recession

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In doing research for the book, I had an epiphany. And what is embarrassing is that this obvious truth has been sitting around for more than a century, but it was buried by Milton Friedman and others: During a financial panic, central banks should raise rates. An excerpt from my Mises Daily:

If the owner of a trucking company experiences a huge rush for his services, he might decide to postpone essential maintenance on his fleet, to take advantage of the unprecedented demand. But during this period he will be charging record shipping prices to make it worth his while to deviate from the normal, “safe” way of running his business. He will only be willing to bear the extra risk (either to the safety of his drivers or just the long-term operation of the trucks) if he is being compensated for it.

The same is true for the banks. Just as every other business during a recession wants to bolster its cash reserves, so too with the business that rents out cash reserves. If there’s a hurricane, the stores selling flashlights and generators should raise the prices on those essential items, to make sure they are rationed correctly. The same is true for liquidity — the moment after the community realizes they are in desperate need of it.

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