At the annual meeting of the American Economic Association in San
Diego (January 4–6, 2013), Harvard professor of economics Benjamin Friedman
The standard models we teach … simply have no room in them for what
most of the world’s central banks have done in response to the crisis.
Friedman also advises sweeping aside the importance of the role of
monetary aggregates. On this he said,
If the model you are teaching has an “M” in it, it is a waste of
students’ time. Delete it.
According to most economic experts, the Fed has re-written the central
banking playbook, cutting interest rates to near zero and tripling its
balance sheet by buying bonds. The federal funds rate target is currently at
0.25%. The Fed’s balance sheet jumped from $0.86 trillion in January 2007 to
$2.9 trillion in January 2013.
Professors who say they agree with the Fed’s approach to the 2008–2009
economic crisis are nonetheless challenged to explain this new world of
central banking to their students. They argue that the dramatic action by the
central banks to counter a global financial crisis cannot be explained by
traditional models of how monetary policy works.
So what seems to be the problem here?
According to traditional thinking, a lowering of interest rates
stimulates the overall demand for goods and services, and this in turn, via
the famous Keynesian multiplier, stimulates general economic activity.
Furthermore, according to traditional thinking, massive monetary pumping
should also lead to a higher rate of inflation.
Yet despite the massive monetary pumping, both economic activity and
the rate of inflation remain subdued. After closing at 8.1% in June 2010, the
yearly rate of growth of industrial production fell to 2.2% in December 2012.
The yearly rate of growth of the consumer price index (CPI) fell to 1.7% in
December 2012 from 3.9% in September 2009. Additionally, the unemployment
rate stood at a lofty 7.8% in December 2012 with 12.2 million people out of
So why has the massive monetary pumping by the Fed, and the near zero
federal funds rate, failed to strongly revive economic activity and exert
visible upward pressure on the prices of goods and services?
Is the comment by Benjamin Friedman, that money is not relevant, now
No. The fact that the massive Fed pumping has failed to produce the
expected results—along the lines of mainstream models—does not mean that the
money supply is no longer important to understanding what is going on.
The fact that economic activity is currently not responding to massive
monetary pumping, as in the past, indicates that prolonged reckless monetary
policies have severely damaged the economy’s ability to generate real wealth.
So contrary to Friedman, we maintain that money matters very much. However,
contrary to mainstream thinking, an increase in money supply does not grow, but
rather destroys the economy.
The ongoing monetary pumping, coupled with an ongoing falsification of
the interest rate structure, has caused a severe misallocation of scarce real
capital. As a result of reckless monetary policies, a non-wealth-generating structure
of production was created. Obviously, with the diminishing ability to
generate real wealth, it is not possible to support, i.e., fund, strong
Monetary pumping is always bad news for the economy because it diverts
real funding from wealth generating activities to wealth consuming
activities. It sets in motion an exchange of something for nothing.
As long as the economy’s ability to generate wealth is functioning,
the reckless monetary policies of the central bank can be absorbed. Under
such conditions, market watchers get the false impression that
"loose" monetary policies are the key drivers of economic growth.
When wealth-generating activity, as a percentage of the total economic
activity, drops below a certain point, reality takes over and general
economic activity has to fall. This decline in wealth-generating activity
undermines the ability to lend. Real funds for lending have also declined and
lending "out of thin air" results. Following suit is the growth of
the money supply and price inflation.
As a result of the weakened wealth generating process, formerly
subsidized non-wealth-generating activities come under pressure. Since they
don't produce enough to sustain their own viability, they are forced to lower
their prices of goods and services to stave off bankruptcy. According to
As soon as the afflux of additional fiduciary media comes to an end,
the airy castle of the boom collapses. The entrepreneurs must restrict their
activities because they lack the funds for their continuation on the
exaggerated scale. Prices drop suddenly because these distressed firms try to
obtain cash by throwing inventories on the market dirt cheap.
It is not clear whether we have already reached this stage in the US.
But despite massive pumping by the Fed, economic activity remains subdued and
this raises the likelihood that the US economy is not far from sinking into a
The Fed's aggressive pumping policies highlight the destructive nature
of loose money. Popular mainstream theories aside, the actions of the Fed
have proven that monetary pumping cannot grow an economy. It can only set in
motion a process of destruction.
Many mainstream policy thinkers are of the opinion that the Fed’s
policies can be made more effective by making the central bank’s policies
transparent and consistent. The following remarks, by the prominent economist
Michael Woodford and reported by Reuters, are but an example:
"The recent events ... have given us a lot of reason to change
what we teach when we talk about monetary policy," said Michael
Woodford, a professor at Columbia University and one of the most influential
current thinkers about monetary policy.
In future, Woodford said he would incorporate a lot more discussion
about the importance of stability in the financial sector on the macro
economy, and tell students why future expectations for central bank interest
rates can be vital.
"Explain why expectations are important for aggregate
demand," he told the panel. . . .
"Make it credible that the central bank will actually follow
through with the policy it is indicating," Woodford said, referring to
the importance of convincing businesses and households to invest and spend.
The belief that greater transparency and consistency in the Fed’s
policies would lead to stable economic growth is fallacious. We have seen
that it is the Fed’s actual policies that are the key factor behind the
destruction of the wealth generating process. Hence, the damage inflicted by
these policies cannot be avoided even if the Fed is consistent and
The key problem with the mainstream perspective is its notion that all
that is needed for economic growth is to boost the demand for goods and
services, i.e., demand creates supply. It is for this reason that mainstream
thinkers held the view that increases in the money supply, and the subsequent
increase in the overall demand for goods and services, is a catalyst for
But we have seen that once money is pumped, it sets in motion an
exchange of something for nothing, i.e., the diversion of real wealth from
wealth generators to non-wealth generators, and subsequently to economic
Summary and conclusion
At the recent American Economic Association meeting, academic
economists said that the latest monetary policies of the Fed made it
difficult to employ accepted theories regarding the effect of central bank
policies on the economy. Experts are of the opinion that in the “new world,”
because of Fed policies, there is little room left for the money supply to
explain why economic activity and the rate of inflation are subdued despite,
the Fed’s aggressive policies since 2008. Contrary to mainstream thinking,
the aggressive policies of the Fed have highlighted the destructive nature of
loose monetary policy. Money
supply matters more now than ever.