How Is the Money Supply Like Gastric Acid? (Well, It’s Complicated #2)

Discussions of banking and financial regulation, at least on social media with non-experts, tend to take one of two fairly absolutist views: either bankers are inherently malevolent extortionists who do nothing more than taking advantage of honest workers’ effort and thus need to be reined in by the watchful eye of government regulators, or the free market is a glorious paradise in which regulation is nothing more than an inefficient and unnecessary evil that hurts everyone by making the market less effective that it could be in producing wealth.  I hate to be the one to tell you, but neither view is correct.  Sorry.  But to see why, let’s take each in turn, and look at some examples.

First, there is little to no evidence that bankers are evil.  In fact, such views have been perpetuated throughout human history, and even underlie many anti-Semitic conspiracy theories (as until the modern era, Christian usury laws meant Jews were the primary financiers of medieval and renaissance Europe).  But the truth is the banking sector is a fundamental base of trade: it provides liquidity and investment capital that allows businesses to operate and expand.  Without investors, only the rich could afford to start businesses.  Thus the financial sector is not only not evil, it is intimately intertwined with every transaction in the modern world.  It allows for the existence of everything from start-up capital to pension funds to widespread home ownership.  Bankers want to make money, sure.  But by and large there’s no evidence they’re any more evil than their fellow non-financial industry citizens.  The existence of occasional bad actors like Bernie Madoff does not refute the vast amount of good that modern financial systems have done to develop economies and build general wealth and fuel trade and growth around the world.

But even with that firmly established, it does not mean regulation is unnecessary.  Even with the absolute best intentions, individual agents in the finance industry operate in a complex system.  Markets are highly interconnected and interdependent networks, and even if we grant the classical assumption that each agent is perfectly rational, the system in which they work means that the market does not act like a classical model would predict.  Rather, because of the high level of interconnectivity and interdependence, thousands of individually rational actors making perfectly rational decisions to optimize their own utility in their local environment interact in complex and often unpredictable ways, and feed off of each other.  What Agent A does in New York affects an investment decision of Agent B in London, which in turn influences the choices of Agent C in Tokyo, and so on for millions of decisions, rippling across the globe.  And all of these decisions are based on outside information as well, like weather patterns (for agricultural commodities futures) or political stability estimates or individual corporate strategies.  This network effect leads to emergent properties like speculative bubbles and market crashes and credit crunches and supply bottlenecks.  We see such inefficient trends even in 100% mechanically deterministic, perfectly rational simulations in agent-based computational models.  It’s even more inefficient when we introduce irrationality and the quirks of human individual and social behavior, like tendencies toward collusion and coercive practices and gaming the system through asymmetrical information and other “unfair” advantages. (For further information, please see the references I’ve listed at the end of this article.  I’ll also be elaborating more on the topic in my continuing Complex Systems series.)

All of these features of markets, especially with the actual human elements, can and do lead to widespread harm, from massive financial losses in crashes even to widespread starvation and death in the case of depressions and economic collapse.  So what, then, can we do to try to control such inefficient emergent properties like irrational bubbles and crashes as supply and demand get out of sync?

To answer this question, let’s briefly turn from economics, and turn instead to the human digestive system, using a metaphor first suggested to me by my dad.  Now, to be clear up front, I am neither a biologist nor a physiologist, so this will be a simplified metaphor to illustrate a point, rather than an examination of the mechanics of digestion.  But the human digestive system has evolved in such a way that it can control the amount of gastric acid in the stomach at any given time.  It does this because, when we were hunters and gatherers, we did not have a reliable source of food, so often our nutrient intake came in brief feasts—after a successful hunt or a profitable foraging effort—punctuated by long periods without food.  Thus the stomach needed to be able to adjust the level of acid, to digest food when it showed up, but avoid hurting itself when there was no food present.  Too much acid without food, and we get ulcers.  Too little acid when there IS food, and we can’t digest efficiently and have to sit around waiting for the food to dissolve slowly.  But the digestive system evolved a way to regulate the level of acid and adjust it as conditions change: keep it low during periods without food, ramp it up as necessary when food shows up, and then lower again to protect itself when the job is done.  This remarkable regulatory system gave us the flexibility to succeed as a species when we didn’t have a reliable food intake, and without it we’d likely have died off long before we figured out agriculture.  It’s not a perfect system: we still sometimes get ulcers, and we still sometimes have digestive problems if we gorge ourselves too fast and the system has to catch up after the fact.  But it works, pretty well, most of the time.

Now take that concept and apply it to the economy.  In this metaphor, food is market demand, and the acid is the money supply: it allows the market to process the demand as necessary.  But much like the stomach acid, a single constant level doesn’t work well.  Too much money supply, and we get massive inflation, and no one can afford anything regardless of demand.  Too little, and no one has money to buy things and trade grinds to a halt, and we might even get deflation (where people know their money will be in more demand in the future, so they’d prefer to hold on to it rather than spend it now).  The money supply, like our metaphorical gastric acid, has to be appropriate to the market’s requirements at the present time.  Therefore, the ability to adjust the money supply is essential to a smoothly functioning economy.  Money supply regulation helps the economy, by and large, by letting the market efficiently process demand through trade, without excessive inflation or deflation.

Now, much like the gastric acid regulatory system, money supply regulation isn’t perfect.  Generally it’s done by central banks like the Federal Reserve, which is a favorite target of free market advocates who are convinced the Fed has made the market worse and attributes many market problems, such as bubbles and crashes, to its interference.  However, there’s some decent evidence showing that’s not the case at all.  About a year and a half ago, I ran some numbers to see if the Fed has really made things worse.  What I found was that in the United States, prior to the founding of the Federal Reserve, depressions and recessions occurred on average every 4.33 years, lasting an average of 2.16 years each, with an average 22.8% peak-to-trough loss of business activity.  Since the founding of the Federal Reserve in 1913, they have occurred every 5.76 years, lasting an average 1.08 years, with an average peak-to-trough loss of only 10.1%.  If we look only at the period since the end of the Great Depression—an event which led to the creation of macroeconomic theory and its application by central banks—they drop to an average of 11 months every 6.33 years, with a peak-to-trough loss of a remarkably low 4.2%.  Now, I freely admit this was not a scientific, econometric analysis.  I did not control for confounding variables, so I’m not going to argue the Fed has itself caused the lower volatility of the markets since 1913.  But I’m not alone in noticing this trend: in financial economics, the period of approximately 1950-2007 is known as the “Great Moderation,” and prior to the 2007-08 crash, some financial and macroeconomic theorists firmly believed we’d “solved” the problem of major recessions, largely through high-level monetary and fiscal policy regulation.  Clearly, we have not (there’s a reason the Great Moderation ended in 2007).  But it’s virtually impossible to look at the empirical data and proclaim that the Fed somehow made things worse.  And there’s a very strong indication that policies such as regulating the money supply HAS dramatically reduced market volatility by matching the metaphorical acid level to the metaphorical food level.

Much like the digestive systems, however, it’s not a perfect system.  The experts and the regulators don’t always get it right.  Everyone makes mistakes and every system fails sometimes—especially when trying to control complex systems like economic markets.  Bubbles and crashes have not gone away even with a guiding hand on the wheel of the money supply.  There’s even some strong evidence that several Federal Reserve policies, combined with the independent actions of other regulators, inadvertently fueled the housing market bubble and risky financial practices that led to the the 2007-08 Wall Street collapse.  I’m certainly not arguing against regulatory reform.  I’m just saying that the idea regulation always makes things worse does not stand up to even the most cursory examination.  Sure, it certainly can make things worse—micromanaging policies add an unnecessary and often harmful regulatory burden that makes companies less effective and the market worse overall—but, if applied carefully and gently in the areas it CAN help, then it can also reduce volatility and decrease the negative effects when market agents get it wrong and everything goes bad.  Bankers aren’t inherently evil actors who exploit those less fortunate than themselves, but complex systems like financial markets mean even when everyone is acting with the best intentions, things can go very wrong in a hurry, and effective regulatory systems can help prevent them doing so or mitigate the harm when they do.

The money supply is just one example of a regulatory system that can help the market as a whole, if used carefully.  It’s certainly not the only one—others include limiting collusion and coercive behavior, reducing the impact of asymmetrical information in decision-making so “insiders” can’t take unfair advantage of the rest of the market, and other regulations that act as referees to keep the market as fair as possible.  But there are clearly harmful and wasteful regulations, too, like burdensome tax requirements and unnecessary micromanaging rules.  “Regulation” is such a broad term that no pithy one line explanation can possible capture the whole picture, and each needs to be examined individually in the context of how markets actually work to understand whether or not its valuable.  Like the title says, it’s complicated.


Further reading:

Eric Beinhocker, The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, Harvard Business School Press, 2006

W. Brian Arthur, Complexity and the Economy, Oxford University Press, 2014