Dr. Bill Woolsey—previously the mayor of James Island, South Carolina, but also a lieutenant-colonel in the US Army, Associate Professor of Economics at The Citadel military training school, and market monetarist/free banking blogger of much repute—is one of my favourite economists. He has a unique way of explaining economic concepts in tightly logical and crystal clear fashion and couples it with a civil, friendly tone. His second-last post—Are Open Market Operations Distortionary?—is a classic example. If there is a central bank, he argues, responding to rises in money demand by creating new money through 'open market operations' (buying govt bonds with newly-created money) is not distortionary. Indeed, it would be distortionary not to respond.
Many of my fellow free bankers agree that when banks accommodate changes in the demand to hold their monetary liabilities, the result is equilibrating and nondistortionary. However, they believe that when a central bank adjusts the quantity of base money to accommodate changes in the demand for it, there is something problematic with the process. The injection of base money is somehow distortionary.
Now, I don't want to claim that this could never be a problem. The Fed's policy since 2008 has most certainly become very distortionary--intentionally Perhaps there should be no surprise that the Fed has attempted to funnel money into housing. Using government interventions of one sort or another to promote home ownership has been the norm for nearly a century now.
I will surely grant that the potential for a central bank to create an excess supply of money is much greater than that of private banks issuing any sort of money. My point is simply that to the degree a central bank limits its issue of new money to the amount demanded, there is nothing especially distorting about the process. It is coordinating.
The proper comparison is not what would happen if the nominal quantity of money remained fixed and there was a deflation of prices and wages. Nor is the proper comparison to what would have happened if there had never been an increase in the supply of saving. The proper comparison is what would happen if there was a increase in the supply of saving by purchasing government bonds.
Read the whole thing.