Friday, July 2, 2010

The Credit-Users

We have one abiding principle: Printing money causes inflation.

We have a rule that arises from this principle: Any time there is inflation, the Federal Reserve must restrict the quantity of money. I'd say it is a good rule, except for one thing: It does not work. The rule did work, but the economy gradually changed, and changes made the rule ineffective.

So now consider the rule: Anytime there is inflation, the Federal Reserve must restrict the quantity of money. Look for a flaw in the rule. I know it is hard to see the flaw, because the rule is such a basic part of our thinking. Here is a clue: Milton Friedman wrote something called "The Optimum Quantity of Money."

Here is the flaw: The rule has no lower limit. It only identifies "too much" money. It cannot identify "too little" money. And this flaw skews our thinking.

According to the rule, there is no optimum quantity of money. No matter how much or how little money there is, if there is inflation, there must be too much money.

The rule allows us to drive down the quantity of money below the optimum without any warning or indication at all. There never comes a time when the rule says, Stop! You've gone too far. The rule never says Something else must be wrong.

If printing money is the only thing that can possibly cause inflation, the rule is great. But suppose something else can cause inflation, something like borrowing money, say. Then it becomes possible -- or even likely -- that the Federal Reserve may restrict money, and restrict it more and more (as the Fed has indeed done) without ever extinguishing inflation

We use credit for money. The policy of eliminating money from circulation was the driving force that turned us into credit-users. But our reaction to policy changed the economy. Once we became credit-users, borrowing money became a more significant cause of inflation than printing money.

And after that, the rule didn't work anymore.

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