What Ron Paul gets right about economics

Ron Paul is onto something when he claims that the Federal Reserve's low interest policy has discourages savings and encouraged borrowing.

Ramesh Ponnuru, senior editor of National Review, has an article criticizing Ron Paul for his economic theories, which is to say he is criticizing Austrian economics.

I won't bother to refute all of his points especially since I've already refuted most of them when put forth by others, but I will mention his denial of the claim that the Fed's low interest policy have discouraged savings and encouraged borrowing.

"Consider, for example, a world in which the Federal Reserve conducts monetary policy so that the price level rises steadily at 2 percent a year. Savers, knowing this, will demand a higher interest rate to compensate them for the lost value of their money. If the Fed generates more inflation than they expected, as it did in the 1970s, then savers will suffer and borrowers benefit. If it undershoots expectations, as it has over the last few years, the reverse will happen. The anti-saver redistribution Paul decries is thus not a consequence of monetary expansion per se, but a consequence of an unpredictedly large expansion. For the same reason, monetary expansion does not necessarily lead to less saving. There is no reason to believe that the real burden of home loans would be any larger in a world with 2 percent inflation than in one with 1 percent inflation."

This would be true if price inflation was entirely caused by factors unrelated to monetary policy actions. If that had been the case we would indeed expect periods of time with unexpectedly high price inflation due to for example crop failures to be compensated by periods of time with unexpectedly low price inflation due to unusually good crops.

But in reality, central banks create price inflation by lowering the real interest rate. They provide free money for the banks at levels below the natural level (time preferences of the population). This in turn enables the banks to lend more which in a fractional reserve banking system means a higher money supply which in turn creates price inflation. Lower real interest rates isn't just the result of higher price inflation, it is in fact the cause.

But what about his argument that savers will demand a higher interest rate? Well, rational savers will indeed do so, but even assuming that all savers are rational (and that's an implausible assumption), it won't matter, because the banks won't need the savers as the central bank can create all the money needed for the banks to lend. All savers can do is either save in foreign currency accounts (which will lower the dollar's value), buy stocks or fixed assets (like real estate or gold) or not save and consume.

Either way, savers behavior can't change the outcome when it comes to real interest rates, at least as long as the central bank is indifferent (or positive) to the inflaionary impact of their money printing. And it should be obvious that the Fed hasn't been significantly deterred from inflating by the effects on price inflation recently.

This point also affect another of Ponnuru's assertions, that Fed monetary policy hasn't enabled government expansion. Lower real interest rates will encourage not just private individuals, families and companies to borrow more, but also government borrowing. And with federal debt at more than $15.4 trillion, or about 100% of GDP (comparable to Portugal) government borrowing enabled by low interest rates have clearly played a role in expanding the size of government.