The real economy and the problem of money

This arises from two recent developments -- the Fed's latest so-called "quantitative easing" moves ("QE2") and the appearance of a column by Richard Salsman in the Financial Post, called "The deflation myth".

The problem or question of money is one that's taken on added pertinence with the Fed's recent manipulations, but it's also one that underlies a deeper issue of state or state-like manipulation of a society's economy. Of four main areas of such manipulation -- direct state ownership or control, state regulation, fiscal policy, and monetary policy -- the last is in many ways the most obscure and mysterious, not only to onlookers but also, I think, to the architects in central banks, as evidenced by the unresolved debates that swirl around it, both contemporary and historic. Part of that problem is that money itself is inherently mysterious or confusing -- it's not just the naive, King Midas idea that money per se constitutes actual wealth, but even the idea of it as just a measure of wealth leads to difficulties, since the question then arises as to what measures the value of money itself? And when these kinds of questions get mixed into the contemporary world of multiple currencies, various measures of the quantity of money, "velocity" of money, money markets, etc., it can easily seem as though the real, underlying economy of goods and services, work and trade, gets lost beneath deep layers of this artificial token of wealth.

So a while back I started to wonder what an economy would look like if you could excavate through those layers of artifice, so to speak, and get back to the real economic activities of production, trade, and consumption themselves. Now, you can't do without money of some sort, but suppose you could at least treat money in a neutral fashion without it being the focus of state manipulation? Of course, the gold standard provided that to some degree, but commodity money possesses its own kinds of mystifications -- suppose, more simply, that we have fiat money, but a fixed or constant supply of it. Or, so that money is unaffected by changes in population, suppose a fixed amount of money per capita -- i.e., the money supply can grow or shrink only as the population does. And, by "money supply" we would mean only money actually held -- in bank vaults, tills, safes, pockets, or mattresses -- not money lent, so that credit would not be considered to affect the supply. No more "quantitative easings", then, and no more playing about with interest rates. Interest rates would move just in the same way prices move, and since the supply of money is more or less constant, they would rise or fall only as demand grows or shrinks -- an automatic countervail for economic booms and busts. We could take the Fed out of the picture altogether, in fact, since all monetary "policy" would now be handled automatically. Would that not tend to remove at least one big source of financial uncertainty, and make economic decisions a little more clear, or at least a little more reality-based?

Well, it's an intriguing thought-experiment. One interesting consequence, however, is that the value of money would still be variable. Since the supply of money is assumed to be constant per capita and since, under the usual conditions of increasing productivity, the supply of goods and services is increasing per capita, a unit of money would have to be a token for an increasing amount of real wealth -- i.e., money would be deflating, exactly to the extent that productivity is increasing (ignoring the issue of "velocity" for now). Now, deflation is usually treated as a horrible development that threatens utter financial ruin, but it's not clear to me exactly why. True, it means that borrowers would have to pay back money that's worth more than when they borrowed it, rather than less as they've been used to; and lenders, of course, would be in the reverse situation. But, as long as both sides knew this up front, which they would, then these changes in the value of money would get reflected in interest rates, just as they are now, though in the opposite direction -- that is, just as both borrowers and lenders typically take account of the inflation rate in order to arrive at a nominal interest rate, so they would in the case of a deflation rate.

I realize their would be complications. And I'm no expert, certainly, but this is where Salsman comes in:

Many economists presume, falsely, that deflation necessarily coincides with (or causes) a contraction in economic output. In fact, deflation by itself in no way curbs the motive to produce, because it doesn’t preclude the maintenance of business profit margins. During the Industrial Revolution, deflation was common. It was also a bullish phenomenon in the second half of the 19th century, the period of the fastest economic growth in human history.

So, back to the thought-experiment: imagine a world in which investors, businesses, and even ordinary home-owners could confine their attention to what's really happening in the real economy without also having to wring their hands worrying about what Bernanke or whoever is going to come up with next -- imagine, in other words, a world without the Fed altogether. As Lenin said, "It's easy if you try."

UPDATE: See Alex Tabarrok's questioning of the Fed's efficacy at Marginal Revolution: "Has the Fed Been a Failure?" And note as well the link to a post on the desirability of deflation that accompanies productivity gains.

UPDATE2: See also Don Boudreaux's post at Cafe Hayek, "Denationalize Money", which links to a George Will column criticizing the Fed's "dual mandate" of both stabilizing money and maximizing employment.

UPDATE3: And here, just to wrap things up, is Tyler Cowan's response to Tabarrok's post above, in which he defends the Fed. Most ominous line: "The world's preeminent military power simply will have a Fed, for the same reason that it has lots of nuclear weapons."

UPDATE4: Okay, I can see this isn't likely to be "wrapped up" any time soon, but here, with a hat-tip to Tyler Cowan above, is Bryan Caplan's "What I learned from the crisis", which, besides lacing into the Fed in general and Bernanke in particular, also has a lot of interesting links.