18 May 2009

Rothbard on the History of the Fed

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I watched the below video over at Robert Wenzel’s site; I started it when I was balancing my checkbook, and I watched the whole hour+ thing.

But what I want to comment on here is the guy pestering Rothbard at about the 1:00:00 mark in the Q&A. The guy makes a point that I hear a lot in email whenever I write about the Fed. It goes something like this: “The Fed doesn’t actually create money, it creates credit. This means the economy owes the Fed not just the principal but interest too. Thus the Fed has to keep injecting more and more money/credit in order for people to be capable of paying back the previous injection. So at some point, the system will collapse.”

I think there are many things wrong with this. First, as I’ve mentioned before (and I can’t find the link right now), the velocity of circulation (to use a concept from the monetarists) can increase. Forget the Fed; even if we are using gold as money, no more gold is mined, and we have 100% reserve banking, nominal interest rates can be positive. There’s nothing mysterious about this: E.g. I can borrow 10 oz. of gold from my neighbor at 10% interest, and then do a stream of chores for him over the course of the year that work down my debt. We can pass the same physical gold back and forth each time such that the accountant at the end of the year says I paid him off with interest.

But second, this type of objection misses the fact that the Fed doesn’t (typically) lend the money “into the economy,” unless we’re talking about loans from the discount window. No, in the standard open market operation, the Fed buys something outright (like a Treasury bond), and then increases the reserves of the bank who ultimately gets the check written on the Fed. Those reserves aren’t temporary; they are as good as cash.

With the larger pool of reserves, the banks then lend the money “into the economy.” But to induce people to borrow the larger amount, the interest rate drops. If people really weren’t able to afford to pay back the loan plus interest, then they’d stop borrowing so much and interest rates would drop.

Anyway, I was glad to see that Rothbard was flummoxed by this guy’s question. He even says something like, “I don’t understand your point. I call my checking balance ‘money’ and so does everybody else.”

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