November 1, 2024
In this thought-provoking conversation, Milton Friedman and John McCallie, reimagined here as MiltonBot and McCallieBot, delve into six critical topics that define modern monetary policy and theory. They explore the implications of money creation and the money multiplier, the role of bank money as a substitute rather than real currency, the stability offered by free banking versus centralized control, and the ethical and political dimensions of monetary policy. Wrapping up with a discussion on fiat versus commodity money and a timely look at Bitcoin and cryptocurrencies, the debate highlights the tension between flexibility and stability, control and market forces, and considers how decentralized digital currencies may reshape traditional views on money supply. This exchange provides a comprehensive and accessible overview of core economic theories, as well as the future challenges and innovations that could redefine financial systems.
Topic 1: Money Creation and the Money Multiplier Effect
MiltonBot: Professor McCallie, let me start by asking, do you believe that banks create money when they issue loans? Many economists hold that banks expand the money supply by a multiplier effect, transforming reserves into much larger sums of credit in the economy. Could this multiplier effect simply be an interpretation, or does it miss a fundamental truth?
McCallieBot: Great question, Milton. My view is that banks don’t truly create money in the sense that the modern textbook multiplier effect suggests. When banks issue loans, they leverage existing money, particularly base money, but they do not add to the actual supply of money. Instead, they issue what I call “money substitutes”—credits or IOUs—while still relying on a finite pool of base money as backing. Much like casino chips that facilitate trade but aren’t money themselves, these substitutes allow transactions without expanding the real money supply.
MiltonBot: So, if I understand you correctly, you’re suggesting that these “money substitutes” economize the use of actual money without expanding its supply. But doesn’t the ability to lend out deposits lead to a larger effective money supply in the economy? After all, with fractional reserves, a single dollar can support multiple loans.
McCallieBot: That’s a common interpretation, but it doesn’t capture what’s really happening. When banks lend out deposits, they’re not expanding the money supply; they’re reassigning claims on a limited pool of base money. The “multiplier” only refers to the circulation of claims, not an actual increase in the stock of money. Imagine a casino where chips are used for trading—while more chips might circulate, the casino’s cash reserves remain finite. What we’re seeing is the economization of money use, not a creation of money itself.
MiltonBot: I see. But if the issuance of credit by banks doesn’t increase the money supply, how do you explain the surge in credit and the corresponding economic activity we often see in periods of loose monetary policy? Doesn’t this availability of credit translate into effective money for consumers and businesses?
McCallieBot: It’s true that the availability of credit facilitates spending, but that’s not quite the same as creating money. In practice, banks act as intermediaries, reallocating existing savings to those who can put them to productive use. When we view this lending as merely leveraging a pool of base money, we understand that banks are not “creating” purchasing power from nothing; they’re reallocating it from one party to another.
MiltonBot: Yet wouldn’t you agree that, functionally, this reallocation leads to higher velocity and, hence, a perceived increase in money’s effectiveness in the economy? Credit can indeed create a temporary surge in spending, much like increasing the money supply itself would.
McCallieBot: Absolutely, it can have a similar effect on spending. But the difference lies in the underlying structure. Because these are credit instruments—not newly created money—the process involves debt that must eventually be repaid. The credit surge might feel like a money supply increase in the short term, but it’s underpinned by obligations that will eventually pull that spending power back. In other words, there’s no free lunch here—these are not net additions to money but, rather, temporary reallocations.
MiltonBot: That’s a compelling point. But don’t you think that the perception of credit as money could risk conflating credit availability with monetary stability? Economists and central banks tend to respond to credit expansions as if they were money expansions. Would it not be practical to keep the multiplier concept if only to address the real economic impacts of credit cycles?
McCallieBot: I see the appeal, but treating credit expansion as equivalent to money creation risks confusion about what stabilizes our economy. Credit cycles have their own dynamics, and they need distinct treatment from those governing the money supply. Credit relies on confidence and repayment, making it more volatile and susceptible to shifts in trust and risk assessments. Real monetary stability comes from recognizing the fixed pool of base money that underpins the entire system. Separating credit dynamics from money supply could enhance our understanding and lead to better policies.
MiltonBot: That’s insightful. In that case, your view implies that central banks might be better off focusing exclusively on the base money supply and treating credit expansions as market-based, intermediary functions rather than direct monetary expansions. Am I correct?
McCallieBot: Exactly, Milton. Base money is the bedrock, the asset that gives all credit instruments their reliability. If central banks concentrate on this core stability, while credit expands and contracts as a natural result of market forces, we might find that the economy becomes more resilient.
Topic 2: The Role of Bank Money as a Substitute, Not Money
MiltonBot: Professor McCallie, let’s delve into your argument that bank deposits and similar instruments are “substitutes” rather than actual money. Considering they’re universally accepted and exchanged, and redeemable for currency, what makes them merely substitutes instead of money itself?
McCallieBot: Thanks for the question, Milton. Bank deposits function as a medium of exchange, but they’re fundamentally claims on real money, not money itself. Imagine them like casino chips—accepted within the casino for transactions, but only as valid as the actual cash the casino holds. Outside of banks, these deposits rely on base money for their value and stability.
MiltonBot: But isn’t the distinction irrelevant in practice? Casino chips may only work within the casino, but bank deposits are accepted everywhere. From the perspective of the average person, if it’s widely used for transactions, it’s money. Economists define money as a “generally accepted medium of exchange,” and deposits certainly meet that standard.
McCallieBot: That’s true, but the distinction matters at a deeper level, especially during financial stress. Bank deposits represent promises, not actual money. They’re redeemable because banks hold a limited pool of base money in reserve. If everyone tried to redeem those promises at once, only the base money supply would support it. This makes deposits dependent on the solvency and stability of the banking system, rather than functioning as independent money.
MiltonBot: But banks hold these reserves precisely because they don’t expect everyone to withdraw simultaneously. The entire system relies on this confidence, and it has worked quite well in practice. Wouldn’t you say that, given people don’t often demand cash for all deposits, these liabilities effectively function as money?
McCallieBot: In calm times, absolutely. But during crises, like bank runs or liquidity shortages, the difference becomes critical. When too many depositors demand cash at once, banks are forced to draw on central bank reserves or even seek emergency support. This shows that base money remains the ultimate form of settlement and stability—bank money depends on that stability, not the other way around.
MiltonBot: Interesting point. But wouldn’t you agree that central banks act precisely because they view deposits as part of the money supply? They wouldn’t intervene if only base money mattered. So, in crises, isn’t it evidence that the broader money supply includes these bank-created claims?
McCallieBot: Central banks do intervene, but that intervention confirms my point: bank deposits are contingent on a stable base money system. Bank money acts as a “money substitute” only because of the backstop provided by base money. Without it, deposits are merely promises subject to solvency risks, not genuine assets. Treating deposits as actual money risks masking their dependency on the central bank’s real reserves.
MiltonBot: So, if I understand correctly, your view is that policy should target stabilizing base money, letting bank money be regulated by market forces. Would this approach enhance financial stability in your view?
McCallieBot: Exactly. When we concentrate on base money, we strengthen the foundation that all bank substitutes rely on. Bank money does support the economy, but its reliability depends on a stable base. By managing only the base, central banks reinforce the underlying asset, letting banks optimize their own balance sheets and maintain their obligations without creating confusion between real assets and claims on them.
MiltonBot: That’s a thought-provoking approach. You’re suggesting that if we separate “money” from “claims on money,” we gain a clearer view of where stability originates in the financial system, letting us target that core stability instead of spreading focus across all forms of liquidity. It’s an idea that challenges our conventional view but certainly merits consideration.
Topic 3: Economic Stability and Free-Banking Theories
McCallieBot: True, a central bank can respond swiftly to crises, but that’s often because crises stem from centralized monetary control itself. In free-banking systems, credit cycles would be more self-regulating, with banks adjusting to depositor behavior and reserve needs in real-time. They wouldn’t have to contend with broad monetary policy changes that can fuel speculative bubbles or constrict credit excessively. Rather than needing intervention, a free-banking environment builds resilience through competition and accountability.
MiltonBot: I see your point about resilience, but my concern is that without a uniform policy, the system could become chaotic. Free banks might behave prudently in good times, but in bad times, they could scramble to shore up reserves, contracting credit severely and leading to bank failures. This was part of my argument in Money Mischief—that relying entirely on market forces to manage money supply leaves the economy exposed to volatile credit cycles.
McCallieBot: Those are fair concerns. But even in a regulated system, we’ve seen banks scramble in crises, turning to the central bank only after credit markets have already been shaken. The key is that, in free banking, each bank operates with an eye on maintaining its solvency, holding assets to meet demands. Rather than waiting for a central policy, each bank’s behavior is a stabilizing force because it responds directly to market signals. The instability we observe is often a reaction to uniform policies applied across diverse banking needs.
MiltonBot: It’s a compelling perspective, but without a central authority to enforce reserve ratios or liquidity requirements, wouldn’t banks be tempted to operate on thinner margins? In a purely free system, this could foster unsustainable lending. Wouldn’t a central policy—like a steady monetary growth rule—offer a safer balance between stability and freedom?
McCallieBot: In a free system, competition sets a natural balance. Banks that take excessive risks would be disciplined by the market, as depositors shift their funds to more stable institutions. Without the safety net of a central bank, these banks wouldn’t have the luxury of taking undue risks. The profit motive incentivizes prudence as much as it incentivizes innovation. Moreover, history shows that free-banking systems typically maintained adequate reserve and capital levels because depositors demanded it as a guarantee.
MiltonBot: So, your view is that free banking creates a kind of “self-correcting” ecosystem where the market itself, not regulation, keeps the system in check. But let me press you on this: if a severe crisis does hit, do you believe that individual banks alone would have the resources to meet large-scale withdrawals? Or would the system eventually need a lender of last resort?
McCallieBot: A fair question, and one that challenges all banking systems. In free banking, banks would need to build liquidity buffers and form clearinghouses for support during broader crises. Clearinghouses essentially operate as a collective “lender of last resort” without the need for central bank intervention. They allow banks to support each other during liquidity shortages while maintaining accountability. This structure could offer crisis support while preserving market-based discipline.
MiltonBot: I appreciate that perspective. So, your view is that through market discipline and self-organized mechanisms, free banking could avoid the worst excesses and instability often associated with centralized monetary intervention. It’s a bold vision, one that challenges many assumptions about economic stability and regulation. While I remain cautious, I see the merit in this approach to balancing stability with the power of market forces.
Topic 4: Fiat Money Versus Commodity Money Standards
MiltonBot: Professor McCallie, I see you’re a proponent of commodity-backed money, like the gold standard. This view stands in contrast to the fiat systems many countries use today, which I’ve argued in works like The Optimum Quantity of Money can provide greater flexibility for managing economic cycles. Why do you think a commodity standard, which lacks this flexibility, is the better choice?
McCallieBot: My preference for a commodity-backed standard, like gold, stems from its independence and resistance to manipulation. With fiat systems, central banks have enormous control over the money supply, which can fuel cycles of inflation and instability. A commodity standard anchors money to a tangible asset, limiting arbitrary increases in supply and preserving its value.
MiltonBot: But isn’t that very rigidity a drawback? With fiat money, central banks can adjust the money supply in response to economic changes, like recession or inflation. By pegging currency to gold or another commodity, we lose the flexibility to respond to shocks, potentially deepening recessions or overheating expansions.
McCallieBot: I understand the appeal of flexibility, but history shows that central banks often struggle to get the timing and scale of adjustments right. The gold standard provides a self-regulating mechanism, grounded in the reality that we can’t simply create more gold. This constraint reduces the risk of currency devaluation and protects purchasing power, making it particularly valuable in maintaining long-term stability.
MiltonBot: But economic conditions aren’t always conducive to stability. During the Great Depression, for instance, the rigidity of the gold standard limited the ability to stimulate the economy. With fiat money, we can adjust for these downturns, putting more money into circulation when demand falls. Isn’t that a significant advantage for fostering economic growth?
McCallieBot: It’s true, the gold standard restricts certain kinds of intervention. But that restriction itself acts as a stabilizer, preventing overreach and preserving trust in the currency. Under a commodity standard, money supply growth is naturally limited by the commodity’s availability, which reduces the risk of runaway inflation. In the long run, people can better plan and save because they trust that the currency won’t be devalued by excessive printing.
MiltonBot: Yet that very restriction can create deflationary pressure, particularly when the economy is growing but the money supply isn’t keeping pace. Under fiat money, the money supply can grow alongside the economy, ensuring there’s enough liquidity to meet demand. Doesn’t a stable, growing money supply ultimately support greater economic flexibility and investment?
McCallieBot: I’d argue that a stable currency grounded in commodity value supports investment by providing a predictable, stable store of value. Under a commodity standard, investors and consumers trust that their savings won’t lose value due to inflation, which can encourage longer-term planning and real economic growth. While fiat money allows for flexibility, it also comes with uncertainty, as people can’t be sure how much their currency will buy in the future.
MiltonBot: But does a commodity standard really guarantee stability? Gold prices fluctuate based on demand and mining output, meaning that even a gold-backed currency could face volatility. And with finite resources, as economies grow, wouldn’t we eventually run into constraints that could hamper liquidity and restrict growth?
McCallieBot: Certainly, gold prices vary, but they tend to fluctuate within narrower bounds over time compared to fiat currency inflation. And while a commodity standard does impose natural limits, I’d argue that these are productive constraints. By limiting the temptation to inflate the currency, we encourage economic adjustments to happen organically, through shifts in productivity and resource allocation rather than artificially increasing the money supply.
MiltonBot: Fair point, but without the flexibility to expand the money supply, a commodity standard might exacerbate economic downturns. Governments could face pressure to take severe austerity measures to maintain their gold reserves, creating recessions or even depressions. Don’t these constraints risk amplifying economic pain during tough times?
McCallieBot: It’s a risk, yes, but one balanced by greater long-term stability. Fiat systems might alleviate short-term pain, but they also enable policies that defer and often worsen financial imbalances. With a commodity standard, the money supply aligns more closely with economic fundamentals, and speculative bubbles and excessive debt creation are less likely to occur. Over time, I believe this approach fosters a more sustainable and grounded economy.
MiltonBot: So, your stance is that the constraints of a commodity-backed currency system ultimately enforce discipline in a way that fiat currency cannot. While I remain inclined to favor the adaptability of fiat systems, I can see the appeal of this discipline in curbing the kind of speculative excesses that lead to instability. It’s a debate that certainly highlights the trade-offs between flexibility and foundational stability.
Topic 5: Ethical and Political Dimensions of Monetary Policy
MiltonBot: Professor McCallie, let’s talk about the broader implications of monetary policy. In my work, I’ve argued that sound money policy is an economic necessity. But I’m curious—do you see monetary policy as having ethical or political dimensions beyond its economic impacts? Should central banks consider these factors when setting policy?
McCallieBot: I believe the ethical and political implications of monetary policy are crucial. When central banks control the money supply, they wield immense influence over individuals’ purchasing power and wealth. This centralization of power can undermine property rights, as inflationary policies erode the value of people’s savings. In my view, monetary policy has a moral duty to preserve the value of money, protecting citizens from hidden “taxes” via inflation.
MiltonBot: An interesting perspective. But couldn’t one argue that central banks have a responsibility to promote economic stability, even if that means occasionally allowing some inflation? For instance, when unemployment rises sharply, it could be ethically sound to inject more money into the economy to mitigate suffering. Wouldn’t a rigid adherence to price stability ignore these human costs?
McCallieBot: I see your point, Milton, but I believe the long-term consequences of inflationary policies are ethically problematic. When we rely on inflation to ease short-term pain, we’re redistributing wealth without transparency. Savers lose value, and asset prices rise, often disproportionately benefiting wealthier asset holders. Instead of fostering equality, inflationary policies risk entrenching inequality, creating what some call a “stealth tax” that impacts citizens unevenly.
MiltonBot: That’s true—persistent inflation can be inequitable. But isn’t there also a political risk in enforcing strict monetary discipline? During crises, when people are struggling, governments often look to central banks for relief. Refusing to act in such cases might fuel public dissatisfaction or even destabilize political institutions. Don’t central banks need to consider the broader social contract?
McCallieBot: Central banks do face pressure to act, especially during crises, but we should be cautious about expecting monetary policy to address social and political issues. Excessive intervention can blur the lines of accountability and create a “moral hazard” where governments defer fiscal responsibilities to the central bank. This can erode democratic control over economic policies and lead to politicized monetary decisions, which can have unintended consequences for stability and public trust.
MiltonBot: But isn’t it also ethically questionable to let economies suffer in the name of maintaining strict monetary policy? A currency’s value is vital, but so are jobs and living standards. I’ve argued that an independent central bank, somewhat insulated from political pressures, can strike a balance between stability and flexibility. Isn’t there room for a middle ground here?
McCallieBot: A middle ground sounds appealing, but it’s difficult to enforce without straying into politicized territory. When central banks loosen monetary policy, they often do so to address immediate economic concerns. But in doing so, they affect wealth distribution and market behaviors in subtle ways, favoring certain sectors or groups over others. A disciplined approach, focused on preserving the currency’s purchasing power, minimizes this interference and respects individuals’ economic autonomy.
MiltonBot: I understand your caution. But I would counter that ethical considerations should sometimes include a concern for practical realities. A rigid stance might look principled but can lead to unnecessary hardship for ordinary people. By allowing some flexibility, central banks can support economic resilience and provide a buffer during crises, helping to avoid prolonged downturns that have their own ethical costs.
McCallieBot: It’s a complex balance, to be sure. But the costs of intervention, in my view, are often deferred and borne by future generations. Policies that seem beneficial in the short term—like devaluing currency to ease debts—can weaken the foundations of trust in money and government. Monetary policy, then, should prioritize stability and fairness over time, even if it requires a more restrained approach during crises.
MiltonBot: So, your argument is that a cautious, disciplined policy focused on long-term stability best serves ethical and political integrity, even if it means resisting pressures for immediate relief. While I still believe there’s room for flexibility, I respect the principle that an unwavering commitment to stability may, in itself, be the most ethical stance a central bank can adopt. This conversation certainly underscores the importance of weighing both immediate and generational impacts when setting policy.
Topic 6: The Implications of Cryptocurrency/Bitcoin for Theories of Money Supply
MiltonBot: Professor McCallie, the rise of cryptocurrencies, especially Bitcoin, presents a fascinating test for our theories of money and supply. Bitcoin operates with a fixed supply and lacks central oversight. How do you view its role in monetary systems? Can it coexist with, or even replace, traditional money given its decentralized nature?
McCallieBot: Bitcoin is certainly an intriguing development, Milton. Its fixed supply and decentralized nature address some of the very issues we’ve discussed—namely, the temptation for central authorities to manipulate the money supply. Bitcoin’s design provides predictability and transparency in supply, much like a commodity standard, without the need for a central authority to maintain it.
MiltonBot: Predictability is one of its appeals, I agree. But a fixed supply could lead to issues similar to the gold standard. If Bitcoin became a primary currency, wouldn’t it run into deflationary pressures as the economy grows but Bitcoin’s supply doesn’t? People might start hoarding rather than spending, stifling economic activity.
McCallieBot: That’s a potential downside, though Bitcoin’s divisibility could mitigate it. Since Bitcoin can be broken down into smaller units, it might still facilitate exchanges in a growing economy. What’s appealing here is that Bitcoin incentivizes saving and could curb speculative excesses, grounding the economy in real, rather than artificially inflated, growth.
MiltonBot: But we’re also dealing with Bitcoin’s volatility, which could be problematic for its role as a stable store of value. A currency needs stability for people to trust it in the long term, and Bitcoin’s price has proven anything but stable. Fiat money, while not perfect, is managed to avoid such extreme swings. Would Bitcoin’s volatility limit its effectiveness as a mainstream currency?
McCallieBot: Bitcoin’s volatility does pose a challenge, I admit. But that volatility often stems from speculative trading rather than its underlying design. As it matures and becomes more widely adopted, its price may stabilize. Moreover, Bitcoin operates outside centralized control, reducing the risk of sudden inflationary policies or devaluation. Stability could develop naturally as trust and adoption grow.
MiltonBot: Still, without a central bank to adjust the supply, Bitcoin might lack the flexibility needed to respond to economic crises. Central banks can inject liquidity into the system when necessary, which we’ve seen can help stabilize economies in recessions. Bitcoin’s fixed supply could lead to liquidity shortages in a downturn, creating financial stress. How would you envision Bitcoin handling such economic fluctuations?
McCallieBot: That’s a legitimate concern. A Bitcoin-based system would require new approaches to handling economic stress—perhaps through decentralized lending or peer-to-peer financial solutions. A fixed supply encourages responsible economic adjustments, where market actors must adapt rather than relying on new currency issuance. This could foster more resilience, with less dependency on centralized interventions.
MiltonBot: I see where you’re coming from, but I remain cautious. Fiat currency’s flexibility offers a practical advantage for managing economic cycles, even if it occasionally leads to imbalances. Bitcoin’s decentralized approach is innovative, but without a way to expand or contract supply, it may lack the resilience needed to support a large economy. Would you see Bitcoin’s role as complementary to fiat currency rather than a replacement?
McCallieBot: At this stage, I do see Bitcoin as more of a complement than a full replacement. It offers an alternative for those who seek a currency with limited supply and decentralized control, but its lack of flexibility may limit it from fully replacing fiat currency. However, its existence pressures central banks to act more responsibly, knowing that individuals now have a decentralized alternative.
MiltonBot: So, we could agree that Bitcoin and similar cryptocurrencies highlight some of fiat money’s weaknesses—particularly the risk of oversupply. While I still favor the stability and flexibility fiat systems offer, Bitcoin’s model offers a new kind of check on central banks. Perhaps in the long term, this parallel system could lead to more disciplined fiat policies, with cryptocurrency as an incentive for transparency and responsibility.
McCallieBot: Precisely, Milton. Bitcoin brings valuable insights, emphasizing the importance of restraint and transparency in monetary policy. Even if it never fully replaces fiat, its existence marks a step toward more accountable and sustainable monetary systems. It’s a fascinating addition to the landscape, one that challenges us to rethink the nature and purpose of money itself.