The Two Markets

how we got central banks

It was during these halcyon days that central banks developed the modern functionality, in pursuit of “stabilization,” of working directly on financial markets, not as an exception but as a rule. These “open market operations” were viewed as entirely novel by Federal Reserve operators in 1922-1923, when the Fed first started doing this, although such operations had previously been undertaken sporadically by other banks.

The tightening and loosening of money market rates became the primary preoccupation of central banks. This, along with reserve requirements by which the banking system was tied into the Fed, promised a new era of control over the economy.

This control, as specified in the Fed’s charter, was to be used to promote economic growth, full employment, and wage and price stability. This new set of goals, which were finally cemented during the years of the Great Depression, was a far cry from the official position under the gold standard of “managing” gold flows according to the so-called “rules of the game.” And there was no lack of critics:

Central bank control of trade, employment or prices is a new and dangerous fancy, dangerous because you cannot get the men of genius to run it. It is a false philosophy left over from the war, when people came to think it was possible to regulate almost everything. As a matter of practical fact, we cannot do much more in the way of control than was already being done before the war. The new school of central bank stabilizationists ridiculously exaggerate the possibilities of control.[1]

Whence, then, the hubris to believe that national economies could be started and stopped as if one pushed and pulled on a lever? The intellectual justification derived from faulty monetary theory. The original form of this is called “the quantity theory of money,” and it conceives of money as a body of tangible tokens or objects (like coins) that run within the same circuit as goods and services – the ordinary market. Hence, increases and decreases in the quantity of money have a direct effect on increases and decreases in wages and prices.

We have seen that this kind of direct relation between money supply and the real economy was a cornerstone of the gold standard system, albeit with the introduction of fractional-reserve banking, which rendered the money supply more “elastic,” but still connected to and determined by gold reserves. Then, with the advent of central banking, gold flows were hindered from having that effect on the real economy. Rather, they were diverted into a secondary circulation – the financial market – which, as we have made clear, runs in a separate circulation.

Therefore – as we already knew – there are not one, but two, monetary circulations and thus two “quantities” of money – but even that is not quite accurate, because money in the modern banking system is not simply there as a determinate quantity, but is created and extinguished in the process of engaging and extinguishing debt.[2] Be that as it may, the unexamined presupposition in all of this was, and is, a single monetary circulation amenable to direct manipulation by the central bank. The most emphatic expression of this is the monetary doctrine of monetarism, but Austrian school monetary philosophy likewise partakes of it. The difference between the two is that monetarists embrace this framework while Austrian-school adherents decry it.

Figure 8 provides a model of the monetarist conception.

Figure 8: The Monetarist Framework of Monetary Circulation
Figure 8: The Monetarist Framework of Monetary Circulation

What immediately meets the eye is the complete absence of the financial market and a separate financial circulation. Indeed, in the monetarist framework, as well as in the Keynesian framework (in which the rentier supposedly has been euthanized; actually, he has only been ignored), this side of economic reality is simply left out of the account altogether. This likewise explains the inability of these schools to explain the modern condition of simultaneous liquidity gluts, zero interest rate policies, and disinflationary stagnation. Our explanation of this phenomenon is forthcoming; but before doing so, we must provide a short résumé of the connecting period between the collapse of the gold standard and the contemporary situation.



[1] Lionel D. Edie, The Banks and Prosperity (New York and London: Harper & Brothers Publishers, 1931), p. 10. Edie was here quoting “an old-school European economist.”

[2] On this point, see the discussion by John Rogers Commons, Institutional Economics: Its Place in Political Economy (New York: Macmillan, 1934), pp. 510ff.